Personal Business

Hot money, smart money

If the stock market goes into reverse, will novice investors sit tight or head for the exits?

Ross Laver November 25 1996
Personal Business

Hot money, smart money

If the stock market goes into reverse, will novice investors sit tight or head for the exits?

Ross Laver November 25 1996

Hot money, smart money

Personal Business

Ross Laver

If the stock market goes into reverse, will novice investors sit tight or head for the exits?

On the stock market, euphoria and anxiety go hand in hand. The higher share prices climb, the more investors chew their nails worrying about a sudden market downdraft that might wipe out a big chunk of their profits.

The nervousness meter these days is well into the red zone. Since Jan. 1, the Dow Jones industrial average in New York has gained 24 per cent, racking up 39 record closes. The Toronto Stock Exchange’s 300stock index has done even better, setting 58 records on its way to a 25-per-cent increase.

Jittery investors can’t decide whether to crack open the champagne or hide under their desks.

For every prognosticator who insists that the rip-roaring bull market still has a way to run, there is another who warns that a cataclysmic sell-off is just around the corner. Adding to the climate of instability is the tidal wave of money cascading into stocks and mutual funds from less-experienced investors. If the market goes into reverse, will those people sit tight or run for the exit, precipitating a crash?

The evidence on that score, while not definitive, is far from encouraging. One recent study, published in the Journal of Portfolio Management, tracked the flow of money into and out of U.S. mutual funds during the decade to 1994. Investors consistently plowed money into asset categories when those categories were near their peaks and pulled money out after they fell—buying high and selling low. “The pitfalls of market timing,” wrote the study’s author, Stephen L. Nesbitt, “are generally not understood by the average individual investor.” Much of the blame, he added, belongs to the investment industry, which bombards customers with advertisements boasting about last year’s or last month’s top-performing fund.

None of this would matter so much if the so-called experts were any better than novices at timing the market. Sadly, that doesn’t seem to be the case. In February of 1995, for example, the U.S. investment magazine Money warned its readers that the pre-

vious year’s stagnant market “resoundingly signalled the end of easy money” and that stocks were about to settle back to their long-term average gain of seven percentage points above the rate of inflation. Yet in the 21 months since then, the Standard & Poor’s index of 500 stocks has rocketed 56 per cent.

Consider also the less than stellar performance records of professional money managers. Of the 171 Canadian equity funds that have existed for at least three years, only 39 have managed to outperform the TSE 300, according to BellCharts Inc., a Torontobased mutual fund research company. The statistics are even worse for Canadian funds that specialize in U.S. stocks: over the past three years, only three of 74 funds have outperformed the S & P 500. Why? Simply because, as numerous studies have shown, professional managers are as prone to error as anyone else when it comes to market timing.

All of this underscores one of the immutable laws of investing: the odds of success are greater when you hold on to your stocks as long-term investments than when you try to call every market turn. The reason is that investors who stay in for the long haul reap gains during the upswings that far outweigh their losses in bear markets. “The evidence is pretty compelling—you would need a tremendous record of accuracy to beat a buy-and-hold strategy,” says Richard Woodward, a former University of Calgary management professor and co-author, with Jess Chua, of a widely quoted study of market timing.

In short, Woodward believes that investors who dump their stocks now, fearing a significant correction, are making a mistake. But he goes even further than that. “People who aren’t in the market yet should be getting in,” he says, citing favorable low interest rates and “the tremendous demographic push” caused by baby boomers saving for their retirements. Adds Woodward: “I think we’re going to be surprised a year from now by how much the market has gone up.” Just remember that when the inevitable down cycle does come, it pays to be patient.