The headlines blaze from magazine titles, book covers, newspapers and websites: "Beat the market!", "Here's the strategy you need!", "Get rich trading!" and "A five-star fund!" The talking heads on television fuel the fire even further, with some of them dancing around like crazed animals, frothing at the mouth and screaming for investors to "Buy!" It's enough to sway the convictions of even the most rational investors. Unfortunately, these seductive siren songs usually turn out to be all wrong. If you've ever struggled to keep up with market fluctuations in your investment strategy, read on to learn more about a simple investment strategy that will keep your returns on the rise.
The Truth
If these masterful investment strategies were as good as their advertisements, wouldn't there be a lot more rich people in your neighborhood? If the strategies can't lose, why do the mutual fund firms, wire houses and discount brokerages book huge profits while the average investor fares worse than an unmanaged index? The answer is simple: The financial services firms get paid even if you lose money.
The Numbers Don't Lie
According to Quantitative Analysis of Investor Behavior (2006), a study by the financial research organization Dalbar, the average investor in an open-ended mutual fund earned a 3.9% total yearly return for the 20-year period ending December 31, 2005. The S&P 500 index earned an annual return of 11.9%. The index didn't just beat the investors, it crushed them! (To learn more, see You Can't Judge An Index Fund By Its Cover and Index Investing.)
Dalbar reports that the average mutual fund investor purchased a fund and held it for just 4.3 years before selling. That was during good times - the holding period slipped to just 2.5 years during bear markets. Neither time period suggests that the average mutual fund investor understands the objective of long-term investing or the risks involved in short-term trading in pursuit of performance. (For related reading, check out Ten Tips For The Successful Long-Term Investor.)
The concept of selling the fund you have in order to purchase something different is encouraged by the idea that better returns can be had if only you choose "the right fund". In seeking this most desirable of all investments, most investors turn to historical performance as their guide. They see a fund with a "five star" rating or a particular sector of the economy (such as technology) delivering "hot" performance, and they trade in their current investments to purchase what they are sure must be "the next big thing". It's a classic mistake. (For more on this, see Digging Deeper: The Mutual Fund Prospectus.)
By the time the average investor is aware of a top-performing fund or industry sector, they are looking at last year's winner. The gains have happened already. The folks that made big money did it last year, last quarter or even last week. It doesn't take long before the investment is overpriced, overvalued and headed downhill. It's the perfect time to sell, but generally a foolish time to buy. Unfortunately, as the Dalbar numbers demonstrate, it's precisely the time far too many investors send their dollars in the wrong direction, buying an investment that is unlikely to repeat its past performance anytime soon.
Even when a few lucky investors do manage to grab on to the tail end of a trend, the strategy of chasing performance usually ends badly. For the most part, these investors are too greedy to sell and lock in their profits. They hold the investment as long as the price is going up and continue to hold it on the way back down - and, when the house of cards folds, they can get hurt.
Doesn't Anybody Win?
There's absolutely no doubt that some investment managers beat their benchmarks. Some even manage the task for prolonged periods of time. That said, even Warren Buffet has down years. It is simply unrealistic to expect that any investment or any strategy will always deliver positive performance. (To learn more about Warren Buffett's investment strategies, see Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)
With that in mind, it is equally important to remember that a bad year does not reflect a bad strategy necessarily. Market conditions change all the time. Factors beyond an individual company's control, such as bad weather, political problems, war, terrorism or simply the need to remodel aging facilities, can cause temporary setbacks. In the long term, these setbacks are just blips on the radar - not a reason to abandon a successful investment.
The Long-Term Trend Is Your Friend
Short-term market performance is unpredictable. Daily price swings occur, sometimes for seemingly irrational reasons, which is why long-term investors ignore short-term distractions. To get a better sense of the long term, take a look at the performance of any major market index over a 20-year period. The trend is for the numbers to move upward. Sure, there are peaks and valleys, but overall, the direction of the movement is up.
Plan to Win
Take advantage of the long-term trend when planning your investment strategy. Accept the fact that your portfolio won't always be in the "right" place at the "right" time, and that you won't always own the "hot" investment. Instead of acting like an amateur and chasing short-term performance, plan your investments like a professional.
Set a long-term goal and then choose a strategy that has a high likelihood of achieving that goal. Make logical decisions, not emotional reactions. Think about inflation and don't count on cash to appreciate at a greater rate. Rely on the time-tested theories of diversification and low-cost investing to help you over the long term.
Conclusion
Although many people manage to build sizable amounts of wealth by jumping from one "hot" strategy to another, the odds are against you if you try to follow in their footsteps. One wrong move and your portfolio's value could suffer irreversible damage. In the long-run, buying and holding will probably leave you at least as well-off, if not better, and it sure is a lot less stressful!
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