294 Chances to Screw Up

April 18, 2012

Being an investor is tough.  Nothing moves in a straight line, except maybe a fake Bernie Madoff-type account.  Everything proceeds in sawtooth fashion, and each up and down seems cleverly calculated to play on your emotions just enough to tempt you to take action at the wrong time.  In fact, we could be headed into a correction right now.  Carl Richards of Behavior Gap has an awesome illustration of the basic problem:

Source: Carl Richards/Behavior Gap  (click to enlarge)

According to DALBAR data, the dips are pretty good at causing investors to bail out.  DALBAR’s most recent study released in March 2012 showed that the average stock fund investor made annual returns of only 3.49% over the last 20 years versus an annual return of 7.81% for the S&P 500.  The average investor “generally abandons investments at inopportune times,” according to their research.  That’s a polite way of saying that investors panic when the market goes down and they sell out, often near the lows.

And there is plenty of temptation.  According to uber-reliable Ned Davis Research, as summarized in this Wells Fargo market update, there have been 294 dips of 5% or more since 1928.  In other words, you usually have three or four chances a year to screw up.  Considering that most investors have a 20-30 year life cycle, that’s a lot of dips to deal with.

Source: Ned Davis Research/Wells Fargo  (click on image to enlarge)

The abundance of opportunities to mess up probably accounts for the short average holding periods for both stock and bond funds—a little over three years.  Maybe that really isn’t too surprising, given that there is a greater than 20% correction every three years or so.  Perhaps investors white-knuckle it through all of the small dips and finally throw in the towel when they get whacked upside the head.  Whatever is happening, it is costing retail investors a lot of money.

There’s a better way to handle this—buy on the dips instead.  If you’ve got a reasonable investment strategy, buying on dips will help your returns.  Even if you are investing in an index fund, buying on dips will reduce your average cost.

For example, you could look at the table above and decide to add new money each time there is a 10% correction.  On average, you’d be adding new money about once a year.  You would probably never hit the exact bottom, but you would be consistently adding at prices below the highs.  Or you could use a different threshold, 5% or 12% or 15%, or whatever.  The idea is just to force money in not at the highs.

Another option is to use a market indicator and add new money when the indicator is oversold.  There’s an example using an ETF over the last five years here, including a calculation of how much it helped investor returns over that time.

Think about the math for the whole market: the average mutual fund investor is earning 3.49%, while the market is earning 7.81%.  By definition, all investors in aggregate have to be earning 7.81%, since all investors are the market.  (John Bogle makes this point all the time.)  The corollary is that some investors have to be earning significantly more than 7.81%.  In other words, if many investors have below-average results, someone has to have above-average results in order to have things average out.

That someone could be you.  Instead of using a market pullback as just another opportunity to panic, why not add new money and give yourself the chance to be that someone with above-average results?

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High RS Diffusion Index

April 18, 2012

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 4/17/12.

The 10-day moving average of this indicator is 66% and the one-day reading is 58%.

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