Low average investor returns are NOT evidence of poor market timing

“If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

                                       Benjamin Graham, author of “The Intelligent Investor” – March 1976

Investors cannot time market. That is a given and it must be so for financial markets to function. If investors had perfect foresight and could anticipate tomorrow’s (or next year’s) market move, their combined expectation would cause these moves today; but they would then have anticipated today’s move yesterday, or last year already…and so it would continue. So no, markets can function only if there are two parties who see the future differently, not definitely, and are willing to trade in opposite ways.

Notwithstanding, most retail investors attempt to time markets, consciously or not. Some buy near the top of a bull market, lulled into a sense of security by steadily-rising prices. They become ‘long-term investors’ once the market rolls over; but typically lose their nerve and sell when sentiment and the market are near their worst.

Others sell too early, believing that a correction is imminent and that a better buying opportunity awaits; they are then forced to watch from the side lines as the market makes new highs for months – even years – on end. They congratulate themselves on holding cash when the market does finally come off, but then buy back in too soon, or they miss the bottom.

Neither of these investor types ever earn the full market return.

Statistics appear to back this up. US market research group Dalbar recently published the latest edition of its “Quantitative Analysis of Investor Behaviour”, which reports on the actual return earned by fund investors. It finds that in 2014, a year the S&P 500 gained almost 14%, the average investor in equity mutual funds made just 5.5%. The same shortfall is evident for bonds: whereas the Barclays Aggregate US Bond Index rose just under 6%, the average investor in fixed income funds gained just over 1%.

This is not just a one-year phenomenon: apparently the average retail investor earned less than one third of the almost 12% pa returned by the S&P 500 over the past 30 years.

These numbers suggest poor market timing by investors, but is that really the case? Investing is, after all, a zero sum game, and just as it is impossible for all money invested to earn an above-average market return, it cannot all earn a below-average return (before fees) either.

The US mutual funds held by retail investors (valued at around $15 trillion) represent 30% of the total US bond and equity market. It seems highly improbable that other investors – hedge funds, private individuals, retirement funds, corporates – continuously earn super-returns. If that were the case, we would know all about it – windfalls of this magnitude (twelve thousand billion dollars pa representing 8% of $50 trillion) do not just fall under the table.

So this interpretation – that market timing causes retail investors to lose some 8 percentage points in returns per year – cannot possibly be correct. It is based on the notion that the average equity investor return is comparable to the average equity market return, and that is not the case.

Switching distorts “average investor return”

This is best explained by way of an example. Assume the market is made up of just two shares, each quoted at R100, held by two investors. Each investor holds one share. Over the course of the year, both share prices double. Mid-year, with both shares trading at R150, the two investors sell their shares to each other.

The quoted year end market return is 100%. But what is the average investor return? Each investor gained 50% (R150/R100) on their first investment, and 33% (R200/R150) on the second one . The average investor return per share for the year is therefore only 41,7%, suggesting a massive shortfall. Yet both investors doubled their initial outlay.

So the average investor return does not tell the full, or even part of the story. The implied conclusion would only be correct if the two initial investors had sold to outside investors, rather than to each other. In that case the market return would be shared by four investors who were not all fully invested over the whole year. Inevitably, their average return (in a rising market) would lag the overall market return.

But the reality is that these four investors could not have owned these shares at the same time, other than by reducing their percentage holdings. There must always be cash on the side. For money to come into the market, money must leave the market. And for money to leave the market, there must be money waiting outside the market.

In a closed-end fund, for one investor to gain access, another must exit. In an open-ended fund, inflows can only invested, if another fund is disinvesting (either to change its asset mix or to fund outflows). This activity may relate to market timing, but it may just as well relate to programmed inflows, as part of a long-term savings plan, and to planned withdrawals, because the investor needs the cash.

And not every trade represents a switch between cash and securities. Much more likely, the majority of trades relate to switching from one fund to another (with a brief ‘cash interlude’). With every trade, the return calculation is re-based. In a rising market, this invariably pulls down the observed average investor return, even if individual investors continue to ride the market return, albeit on a different horse.

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