It has been my observation (confirmed by numerous studies) that almost every time retail investors try to outsmart the market, it backfires on them. I humbly admit that I stopped predicting the short-term direction of the markets a long time ago, when I realized I am terrible at it.
Typical investor mistakes usually involve unfortunate timing for shifting money in or out of the market, getting more conservative or aggressive, or moving in or out of specific sectors at the wrong times. This is not because investors are dumb, although the market can make you feel that way. It is just that good investing is counter-intuitive.
One factor that makes market timing dangerous is that so much of the market’s returns come in quick, unpredictable bursts, such as we saw immediately following the election. In fact, there are 1,020 months in the 85-year period from 1926 through 2010. The best 85 months (or just 8.3% of the months) provided an average return of 10.7%. The remaining 935 months (or 91.7% of the months) produced virtually no return (just 0.05%).
Sometimes investors are totally unaware that their seemingly logical decisions are being influenced by personal biases. This is important to recognize now more than ever. Some of our clients are very excited by the new administration and others are basically terrified.
A 2012 study “Political Climate, Optimism, and Investment Decisions” concluded that investor optimism is significantly influenced by political affiliation and the current political climate. Among the authors’ findings were:
- Individuals perceive less risk and are more optimistic when their own party is in power. This leads them to accept more risk and adopt more of a “buy-and-hold” strategy.
- When the opposite party is in power investors tend to opt for safer investments, and are less likely to stick with their decisions as they expect the worst from the new administration. More trading is consistently associated with lower returns.
Evidence of the political investment bias could be seen in a recent survey, called the Spectrem Affluent Investor and Millionaire Confidence Index. It showed that respondents who identified as Democrats prior to the election showed higher confidence levels than respondents who identified as Republicans or Independents. This completely flipped after the election. Democrat investors registered a confidence reading of -10 in December, while Republican and Independent investors showed confidence readings of +9 and +15, respectively. The reality is that over the past 50 years or so, the market has done almost equally well regardless of which party is in the White House.
What’s important to understand is that if you abandon your plan and sell, there’s never a clear sign telling you when it’s safe to get back in. Usually, investors do not feel more confident until the market has moved much higher.
The morale of this story is: Your risk tolerance and investment plan should not change regardless of who is in office.
Have a great week and let’s hope for great Super Bowl commercials.