Why so many lose in a winning game

Despite the long-term outperformance of equities compared to other asset categories, many stock and mutual-fund investors still manage to lose money. Why is this the case, and how can you avoid the same trap?

Stocks, in aggregate, not only provide positive returns over most periods of at least 10 years, but they outperform the other investment categories. Despite this, it seems that many investors still manage to lose money in equities. How can this be?

When share prices increase in value, they attract attention. And the longer and more pronounced a bull market, the greater the attention. What’s more, the longer the bull market, the more money investors are willing to invest in stocks. The opposite is also true, though probably to a lesser extent. As share prices decline, investors tend to stop investing. And some actually sell during periods of falling values.

Performance attracts money

Suppose an equity fund has $100 million in assets. And this fund doubles in value over three years. That’s a compound annual growth rate of 26 per cent. And any fund that does so will attract considerable attention.

Now, suppose investors add a further $200 million to the fund at the increased valuation. Further suppose the fund then loses 3.0 per cent over the next year. Voila! Twice as many losers as winners. Even in a fund that, over four years, produces a compound annual growth rate of 18 per cent.

This may seem hypothetical. But in fact, it’s an understatement of what happens to many funds. It rests on the accurate assumption that investors will continue to put money into a winning fund until it stops winning. And the further accurate assumption that sooner or later, all funds run into at least temporary periods of poor performance — if only poor in relation to other funds in the same category.

We cannot think of a single stock fund that has performed in the top half of its category 10 years in succession. What’s more, few manage this seemingly modest feat as often as seven times in 10 years.

So, it’s likely even the best performing stock funds have suffered at least one poor year in the last 10 — probably leading to a slowdown of investment in the fund if not outright net redemptions. And if the preceding years saw a sharp inflow of investment, the fund may have more unhappy unit holders than happy ones.

Better to follow the advice of legendary mutual-fund manager Peter Lynch. If you’re happy with the management of the funds in your portfolio, add new money to those with the worst short-term record.

This advice can also apply to individual stocks. If you’re confident of a stock’s basic fundamentals, use episodes of share-price weakness as buying opportunities. Often these episodes occur when a company has had a weak quarter or two—or perhaps even a weak year or two. But if, over a five-year period or so, prospects for the company look positive, then it’s a time to buy while its stock is down.

And remember, you can cope better with stock-market volatility if you have ensured that your cash needs will be met in timely fashion. This way, if markets do correct sometime soon, you have the flexibility to buy when stocks are down with less fear.

Should I invest now?

Investing is an activity that requires decisions. But decisions mean risk. And risk may lead you to waffle, or postpone your decisions.

How many times have you heard an investment counselor or media commentator suggest inaction during “these uncertain times?” Or how often has someone suggested that “in the short run, wait and see which way the economic dice actually roll?”

Problem is, all times are uncertain. Of course they are. If they weren’t, all investments would be just like guaranteed investment certificates. And the returns would be the same too.

But we know that, on average, equities provide better returns, over time, than do GICs. The challenge, of course, is in trying to buy an ‘average’ stock or mutual fund. The best way we know to do this is to sidestep low-quality stocks or funds and build a portfolio of equities that fits your needs. Also, follow another bit of investment wisdom—buy gradually and sell abruptly.

Dollar-cost averaging is one way to buy gradually, letting you purchase more equities when they’re cheap and less when they’re expensive. In these uncertain times, we recommend making the decision to invest, getting started with an organized program and sticking with it.

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