I found myself pondering bad behaviour after being drafted as a possible juror for a murder trial. To escape from the drudgery of waiting for the judge to make his way through the pool of prospective jurors, my mind turned to the accusation that investors are poor market timers.
If you've been interested in the markets for a long time, you've probably encountered more than a few people who suffer from the old buy-high, sell-low disease. They're the sort who like to rush into stocks at the tail end of bull markets only to jump out – at much lower prices – during bear markets. They went all-in on Nortel in the late 1990s, tarried too long and were wiped out a few years later.
All stock pickers – myself included – suffer painful losses from time to time. It is the nature of the business. But it's hard to make a convincing case that investors are poor timers in general. Nonetheless, more than a few studies indict mutual-fund investors as being poor timers in particular. Fund investors are regularly put under the microscope because a wealth of easily accessible data has been collected on them over the years.
For instance, some advisers like to cite DALBAR's annual study called the Quantitative Analysis of Investor Behaviour, which usually shows that fund investors suffer from particularly poor returns.
However, the research was recently criticized by Wade Pfau, the professor of retirement income at the American College, who penned an article in Advisor Perspectives called A Warning to the Advisory Profession: DALBAR's Math is Wrong.
The professor details calculations that support his stance, but DALBAR refutes his assertions. (DALBAR's initial response to the professor's findings was attached to the end of his article and the firm also provides additional commentary on their website.)
Unfortunately, it is hard for outside observers to fully test either party's claims because the research reports in question – and the data they're based on – are not freely available for public scrutiny.
Morningstar also reports on investor behaviour and the firm is forthcoming about its methodology. Simply put, it compares time-weighted returns (which mimic the experience of buy-and-hold investors over the period in question) to dollar-weighted returns (which account for the flow of money into, and out of, the funds.) The Morningstar study, Mind The Gap 2016, determined that fund investors suffered from an average annual return gap of minus 53 basis points during the 10 years through to the end of 2015. That is, the dollar-weighted returns were lower than the time-weighted returns. But all was not lost for fund investors because they fared better in low-cost funds and in less-volatile funds.
There are potential problems with attributing the difference between dollar-weighted and time-weighted returns solely to behavioural issues. I addressed some of them earlier this year in an article called The Brain-Bending World of Money-Weighted Returns.
Rather than focusing on fund investors, it's useful to step back and consider stock investors more generally. When you do so, the bad-timing argument runs headlong into a powerful passive investing concept from Stanford Professor Emeritus William Sharpe, which he details in The Arithmetic of Active Management. Simply stated, active investors – as a group – are doomed to achieve market returns on a before-fee basis.
Think of it this way. For every investor who sells their shares in a panic during a crash, there is a buyer on the other side of the trade – such as a Warren Buffett or a Charlie Munger – who snaps them up at bargain prices. As a result, while individual investors can and do suffer from poor timing, other investors benefit. Yet, overall, the money invested actively earns the market's return on a before-fee basis. (Active funds – as a group – are poor long-term bets once fees are taken into account but that doesn't go to the question of timing.)
While there are caveats and complexities that apply around the edges of the argument, the evidence doesn't support the bad-timing accusation when it comes to stock investors in general. It applies only to particular individuals and sub-groups. Even then there is hope for bad timers who can reform their ways over time.
Want to interact with other informed Canadians and Globe journalists? Join our exclusive Globe and Mail subscribers Facebook group.