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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Over the past 45 years, the stock market has lost more than 20% each time three warning signs flashed simultaneously.
