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Leaving the Stock Market Alone

“I’ve never made money in the stock market, so I don’t want to put my money there.” Investors with this belief are not alone, according to the latest research from Dalbar, Inc. Many people, including some investment advisors, don’t make much money investing in stocks and bonds. Dalbar has figured out why.

Dalbar, a leading financial services market research firm, conducts an annual survey called the Quantitative Analysis of Investor Behavior (QAIB). This measures the effects of investor decisions in buying and selling securities over short and long terms.

The latest QAIB found that investment results depend more upon the investors’ or advisors’ behavior than their knowledge of markets or investment strategies. The results consistently show those who hold their investments are more successful than those who time the market. Not only do average investors do worse than those who hold their investments for a long time, in many cases they do much worse.

“Timing markets” does not mean actively moving in and out of securities or mutual funds on a daily, weekly, or monthly basis. Dalbar defines a market timer as anyone who holds an allocation to stocks, bonds, or mutual funds for less than five years. The average investor and advisor hold their investments just over three years.

It isn’t that investors and their advisors get the direction of the market wrong most of the time. They were right 67% of the time. Dalbar finds that withstanding the temptation to sell when investments drop in value is far more important to overall returns than a sound investment strategy. The research shows it is easier for people “to make the right decision when markets are rising and their fear of loss is not the major decision driver.” When markets fall and fear sets in is when investors really hurt themselves by selling out.

How poorly did those who time the market do? Over the past 20 years (from January 1, 1991, to December 31, 2010) they averaged a 3.83% annual return on their stock portfolios. Had these investors put their stock allocation into an S&P 500 Index fund and left it alone, their return would have been 9.14% a year. That’s a stunning difference of 5.31%. On bonds they did even worse, earning 1.01% a year. Had they simply put their bond allocation into a bond index fund that tracked the Barclay’s Aggregate Bond Index, they would have averaged 6.89%.

To compare something shorter and more recent, let’s look at the last five years. Indeed, investors and advisors did a little better in their stock portfolios, but they still didn’t beat the S&P 500. They earned 1.61% a year while those holding the index returned 2.29%. But they still got clobbered in their bond investments, earning an average of .86% annually while the index returned 5.80%.

The takeaway from this and other academic research is clear: spend your time and emotional energy selecting a good mix of asset classes and mutual fund managers within each class, and then leave them alone. This is doubly important when markets are doing poorly. The best mutual fund manager in the world can’t overcome a decision to sell in a down market.

There are times when selling a fund is appropriate. Consider selling mutual funds if managers change their investment philosophy, raise their fees, or begin consistently underperforming other managers in their asset class. Otherwise, it’s best to focus on annual rebalancing to keep your portfolio at its original asset allocation.

Then you can be one of the investors who say, “I keep putting money into the stock market, because I make money there.”

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