Friday, October 4, 2013

When to Stop Betting

I have a friend who keeps asking me if the stock market is going up or down. My answer is always, “Yes, it is.”  But he keeps asking.

He never asks in the same way twice. One time it’s, “Should I wait to sell my stocks until after the government shutdown?” Another time it’s, “Should I wait to sell stocks until my portfolio reaches a million dollars?”

I have answered in several different ways, each time explaining that no one knows whether the market is going up or down. No one. Ever.

Oh, everyone guesses and some of them will be right, but no one prognosticator is right consistently. As my grandfather used to say, even a blind chicken finds a kernel of corn now and then.

Once I reminded him that our mutual friend lost his entire savings, four million dollars, a few years before retiring by trying to eke out a few more dollars from his tech stock.

I’ve told him I knew dozens of paper millionaires at AOL who rode their stock options from $102 a share to worthless, convinced the entire way that the stock would recover if they just hung on long enough.

This is probably the most important thing to understand about investing. No one knows where the market is going.

Behavioral finance tells us that we want to believe that we are all above-average investors, like the children in fictional Lake Wobegon. Studies show us that most investors’ returns actually lag the returns of the funds they invest in and no fund consistently beats market averages.

To quote Morningstar, “In fact, in every diversified stock-fund category and all but a handful of sector categories, funds' 10-year investor returns lagged their total returns. The divergence was, in several cases, quite striking.”

The problem, as Morningstar notes, is that investors pick poor times to buy and sell. Fund return averages look better because they never sell.

So, most fund managers under-perform market indices and most investors under-perform the funds they purchase. Yet, we still want to plan retirement based on historical market index returns.

Another thing we want to believe is that there is an intrinsic 8% (or 10% or 12%) return to be had in the market if we just find the right system. Dollar cost averaging, buy and hold, systematic withdrawals. If we believe in the fairy dust, in time we’ll get our 8%.

An analysis by Business Insider, however, shows that since 1871, the stock market has returned an 8% or more annual CGR in only 21% of the 240-month (20-year) periods.

The idea behind dollar cost averaging is that making smaller sales or purchases over time might be safer than making one large bet immediately. That theory was debunked ages ago. You’re better off taking the plunge.

So, will waiting to buy or sell result in a loss or a gain? 

Yes, it will. I just can’t tell you which.

What I keep telling my friend is that the only answerable question is whether he is ready to stop betting.

And only you can answer that.

1 comment:

  1. This is a very informative topic you have covered here. Keep writing!