Value Investing and the Cost of Market-timing
As you know, we are big fans of using academic research and financial science to intelligently guide portfolio construction. A centerpiece of our investment philosophy is the concept of “value investing” — systematically buying underpriced assets that have fallen out of favor, and periodically selling securities once they have become overpriced. The value phenomenon has been well documented, all the way back to Warren Buffett’s famous investing teacher, Benjamin Graham in his 1934 classic book, Security Analysis, to more recently the research of Drs. Eugene Fama and Kenneth French, who in 1992 first published their approach to utilizing the “value factor” in portfolio construction which propelled it into nearly every business school and investment analytics system in the world. Dr. Fama won the Nobel Prize in Economics for his contribution to this research in 2013. According to wide academic research, value strategies have consistently delivered additional returns over equivalent capitalization-weighted market portfolios (think S&P index funds) for the last 90 years. We call this a “persistent and pervasive” factor in our investment philosophy, making it fundamental in considering how to invest in stocks.
Recently, one of the analysts we follow, Dr. Jason Hsu of Research Affiliates, published updated research that reinforces the impact of a value-oriented approach, but also investigated why most Do-It-Yourself (DIY) Investors, and indeed some professional advisors, fail to realize this value premium in their returns. For example, Dr. Hsu and his colleagues after examining the history of value fund performance found that the average investor doesn’t earn close to the reported performance of the fund they were actually invested in? How is this possible?
To find out, Hsu’s team analyzed the publicly available performance history of both retail and institutional value equity fund managers from 1991 through 2013. They compared the Time-Weighted Return, also known as the “Buy and Hold” return, of the funds’ performance to the Dollar-Weighted Return which incorporates the impact of investors pushing cash into or out of funds at various times — often referred to as “market timing.” Sadly, it comes as no surprise that the average DIY investor typically does not hold their investments. Instead, they chase trends, allocating cash away from value funds after a period of underperformance and towards them again after a period of outperformance. This costs them money. As you can see in Table 1 above, this costs them on average 1.31% per year. 1.31% may not sound like much, but on an annualized basis, because of compounding, this emotional decision reduced the average investor’s return by more than 24%! Dr. Hsu and his team attribute this return gap to investors’ poor market timing decisions as they reallocate assets among funds on the basis of recent performance. Looking beyond just Value stocks, the researchers next turned their attention to all equity funds and found even worse results for the DIY investor. As you can see in Table 2, across all funds, average investors tended to dramatically underperform the investments they were actually invested in because of their tendency to chase trends.
The implications of Research Affiliates’ and Dr. Hsu’s research reinforces our belief that value-oriented investing should remain a cornerstone in portfolio construction, but just as importantly, that keeping a steady hand during both market corrections and market rallies is crucial if investors are to earn this excess premium from their investments. To realize the best return, investors have to be willing to buy value stocks when they are on sale, most often during market corrections, and then hold them for the time required to realize the excess return they offer — even though this will often require patience and determination in the face of lots of hero-of-the-day managers who are promoting recent rave performance. Just as critical, as value stocks grow and eventually become overpriced (meaning they are no longer “value” stocks) it is necessary to take gains and reduce stakes in investments that have been your best recent performers. This is the essence of a “buy low, sell high” strategy and it underlies our rebalancing methodology and that of the institutional managers we recommend.
Each year, financial research firm, Dalbar updates its quantitative analysis of investor behavior which shows how the average DIY investor performed over various time periods in comparison to the markets. The findings don't change much year to year and consistently show that the average investor earns considerably less than the funds in which they are invested. The cause is confirmed by Dr. Hsu’s research. Most DIY investors cannot maintain their discipline when markets are overheated or when they’re heady, and during market corrections when emotions are especially high they tend to let their normal human “fight or flight” response influence their investment decisions. This is when most investors turn a short-term portfolio set-back into a permanent realized loss. Most never recover.
The benefit of having a competent professional financial advisor at the helm during these times is critical. Just when most DIY investors are fleeing stocks, a good financial advisor can remind you that this is your best opportunity to profit from other investors’ impatience. By sticking to a proven asset allocation in both good markets and bad, and rebalancing to buy value assets at attractive prices, investors can measurably increase their long term returns.