In pursuing higher returns, many investors attempt to time the market.
Recent research from Morningstar suggests that this strategy tends to reduce profits instead of growing them. The study reveals that investors often buy into funds following a strong performance period, causing them to miss out on the most significant returns.
This costly timing error was measured by comparing total returns from a buy-and-hold approach with the “investor” return. The latter tracks asset flows into a fund during a certain period, reflecting the return of investors trying to time their entry point. A five-year retrospective by Morningstar showed that UK investors lost 7% when they tried to time the market compared to those who bought and held.
The Gap in Returns: Timing versus Holding
UK-domiciled funds have provided an average annualised return of 4.46% over the past five years. In contrast, the “investor” return was 4.14% per year. While this may seem like a small difference of 0.32 percentage points, it represents a 7% gap in total returns.
Morningstar’s research covered funds across six regions, including Ireland and Luxembourg. It concluded that all investors would have fared better with a buy-and-hold strategy.
The Impact of Behavioural Biases on Investment Returns
The poor returns from investors attempting to time the market can be attributed to human behavioural biases. Morningstar explains that investors often follow the crowd when markets rise, buying into funds that have recently performed well but might be overvalued. This strategy causes them to miss out on the best returns. Conversely, they tend to avoid underperforming funds that could be due for a rebound.
Navigating the markets has been challenging in recent years. Events such as the Covid-19 pandemic and the Russia-Ukraine war have led many investors to abandon their funds out of fear, while others have been tempted to chase returns in sectors such as technology.
The Fallacy of Chasing Big Gains
The study indicates that investors often fare better by sticking with their investments rather than trying to time the markets for big gains from gimmicky funds. In fact, less volatile and simpler funds have yielded better results.
Niche investment funds, which can be volatile due to their focus on a single sector or country, were identified as the most susceptible to poor investor behaviour. For instance, one such fund doubled in size and delivered a 140% return in 2020 before experiencing two years of losses and a halt in asset attraction.
The Dangers and Successes of Market Timing
While the fund’s total returns showed a 17% annualised performance over the 2018-23 period, the estimated investor return was negative 3% per year. This was because most investors entered the fund after its strong returns, just in time to experience subsequent underperformance. Other risky sectors for DIY investors included China and India equity funds.
However, the research also found some successful market timing instances. For example, investors timed their entry well into fossil fuel energy funds, with the most monthly flows in BGF World Energy coming in April 2020. This was before the fund nearly doubled in size due to higher resource prices throughout the year.
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