Buying High and Selling Low: Why Trading Can Destroy Your Portfolio

October 26, 2015

Like so many things in life, investing looks so easy when looking backward. When we look at a historical chart we all wish that we had sold when the market reached its top and bought when the market reached its low. If only we had ‘timed’ the market correctly, our investments would have soared. And yet life and investing are not that easy. In fact, investors are notoriously terrible at market timing. By selling into market downturns many investors (and many advisors) enter a ‘buy high’ and ‘sell low’ cycle, destroying return and putting their long-term goals at risk.

 

The problem is that many investors misunderstand how the stock market works and only want to invest “when things get better”. Alternatively, they want to move to cash when there is negative news. The problem with this type of thinking is that it is often the exact opposite of what investors should do. The best investors are, as Warren Buffet says “greedy when others are fearful and fearful when others are greedy,” something that is incredibly difficult to do and requires an immense amount of discipline.

 

Consider for a moment the stock mutual fund inflows and outflows over the past 15 years. Equity fund inflows indicate that investors are moving into to stocks, while equity fund outflows indicate that investors are moving to cash or other non-stock investments. The market’s largest inflows have often preceded market tops! These periods likely represent periods of euphoria when investor confidence was higher than justified, often during periods when there was a flurry of good news. Conversely, the largest equity fund outflows have occurred at or near market bottoms, likely due to unusual investor pessimism, often during periods of negative news.

 

HISTORICALLY, MANY INVESTORS BUY TOO HIGH, AND SELL TOO LOW1

 The market’s largest core equity inflows have often preceded equity bear markets.  The result, due to making decisions based on the heat of the moment and the news of the day, is that many investors have underperformed the very mutual funds that they owned. Even worse, by trading on fear or greed, they have put their long-term goals at risk by significantly underperforming the market.   Specifically, in the decade leading up to Dec. 31, 2014, investors in US stock funds received a pre-tax return that was about 13% lower than the funds in which they invested according to Morningstar.4 (The lower “investor return” figure reflects the asset-weighted average 10-year total return, as opposed to the average 10-year total return.)

 

The fund flows of the last few weeks tell a similar story. You may be surprised to hear that with only a few days left October 2015 is shaping up to be one of the best months for the S&P 500 since 2011. Yet, an analysis of the funds flows shows that investors were moving out of stocks throughout September and half of October, selling into the market downturn and destroying value along the way.2 Only now that the S&P 500 has jumped 11 percent from its summer low are investors returning to stocks.

 

The lessons to be learned are far from simple. On the contrary, we believe that investing is difficult and requires an immense amount of discipline. First, we believe in investing with a purpose, and that a diversified portfolio, properly constructed to achieve your goals, will give you the best chance of achieving your goals. Secondly, we believe that there is a significant value to having a long-term mindset. Understanding what is happening in the big picture helps us from overreacting to today’s news. Lastly, we believe that it is important to be analytical rather than emotional in decision making. By focusing on fundamentals, we are able to parse through the noise of the news cycle and have confidence in the investments we are making.

 

If you have been caught in the cycle of buying high and selling low you are certainly not alone. We mere mortals are bound to make decisions in the moment with the information that we have at the time, making market timing far more difficult than it would seem. And yet, we believe that there is hope for the disciplined long-term investor. If you would like to get off the cycle, we would be glad to help. Please feel free to call any time.

 

1 "Buying High and Selling Low: What the Equity Flows Show." GSAM Connect.  July 16, 2015. https://assetmanagement.gs.com/content/gsam/us/en/advisors/resources/gsam-connect/2015/buying-high-and-selling-low-what-the-equity-flows-show.html.

2 "Lipper Fund Flow Report Newsline."  Thomson Reuters. 2011. http://www.lipperusfundflows.com/#create:home:Home:/php/signup_trial.php.
3 Jackson, Anna-Louise. "Stocks Roar Back as S&P 500 Heads for Best Month in Four Years." Bloomberg. October 23, 2015. http://www.bloomberg.com/news/articles/2015-10-23/stocks-roar-back-as-s-p-500-heads-for-best-month-in-four-years.

 

4 Source: Hedge Fund Research, Bloomberg, SIMFUND, Goldman Sachs Asset Management. Starting point selected given longest common index inception (HFRIFOF inception /1/1990) through 3/31/2015. Bear markets are defined as periods in which equities realized at least a 15% pullback. Challenging environments are equity bear markets. Outperformance figures shown are cumulative during each equity bear market. S&P 500 is shown as a market indicator for core stocks, as it may represent the most widely followed industry benchmark. GROWTH OF $100: A graphical measurement of a portfolio's gross return that simulates the performance of an initial investment of $100 over the given time period. Largest inflows and outflows are largest monthly flows in the Morningstar Large Blend, Large Value, and Large Growth categories since 1993, the inception of monthly flow data. The example provided does not reflect the deduction of investment advisory fees which would reduce an investor's return. Please be advised that since this example is calculated gross of fees the compounding effect of an investment manager's fees are not taken into consideration and the deduction of such fees would have a significant impact on the returns the greater the time period and as such the value of the $100, if calculated on a net basis, would be significantly lower than shown in this example. Past performance does not guarantee future results, which may vary.

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DISCLOSURE Information on this website and others should be used at your own risk. Past performance does not guarantee future results. Securities investments involve risk; returns in such investments vary and may involve gain or loss. The materials and content herein are not a substitute for obtaining professional tax, personal financial planning, or other relevant financial advice from a qualified person or firm. For full disclosure click on the disclosure link at the bottom.

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