There is nothing quite like watching a home run in baseball. The thrill of the long ball captivates both the audience and the batter. But this preoccupation with home runs often costs teams the game. In his book Moneyball, author Michael Lewis chronicles how the Oakland Athletics baseball team managed to have a string of successful seasons against top clubs despite having one of the lowest player payrolls in the league and without leading the league in home runs
Billy Beane, the general manager of the Athletics, believed that the focus of baseball was all wrong – home runs are fun to watch but home run hitters are among the highest-paid players and also tend to strike out a lot trying to aim for the fences. For instance, Babe Ruth – one of the greatest to play the game – broke all kinds of home run records, but he was also the strikeout king. Mr. Beane believed that a player's on-base percentage (a measure of how often a player reaches base) was a better predictor of success than the number of home runs that he hit because players who get on base are, by definition, in the game and have a chance to score; swinging for a home run often means that the player strikes out completely.
The same concept can apply when it comes to investing. It is often better to slowly and steadily build your investment portfolio than to try and swing for the fences, with flavour-of-the-day stocks or asset classes. Because if you chase high returns, which come with high risks, there is a good chance that you could be out of the game.
Simple math shows that if your portfolio is down 20 per cent, you need to generate a 25-per-cent return going forward just to break even. For instance, if you started off with $10,000 and your portfolio declined to $8,000, you now require a 25-per-cent return just to get back to the original $10,000.
Unlike Babe Ruth, who among other feats was famous for predicting where his home run would land, most humans are bad at predicting the future. With this in mind, what happens when investors try to time the market?
The accompanying chart plots net cash flows to equity funds versus equity market returns. It shows that equity fund flows tend to increase as returns increase and vice versa. But, if you look at the periods circled – in 2002, 2008 and 2011 – those who fled the market missed the massive rallies that followed. They tried to time the market and got hurt.
How do we, as investors, avoid the temptation to chase a bad pitch? Research shows that willpower is a muscle – making choices tires the willpower "muscle," and leads to reduced self-control for subsequent decisions. In essence, this means that investors that give themselves the luxury of making investment decisions based on every new piece of information that comes in, risk depleting their self-control – and thereby expose themselves to fear and greed and the negative consequences these emotions can have on their portfolios.
A simple illustration will demonstrate the point. Imagine an investor invests $10,000 in the market in 1994. For simplicity sake, we assume that the investor invests directly in the index (i.e. no fees), pays no taxes and that there are no transaction costs. In this world, over the past 20 years, reacting to news would not have produced the best result. Lack of self-control would actually have cost the investor.
Investor A has a strategy of buying the prior year's top performing asset class (something that is not uncommon among investors) and achieves a portfolio value of $45,958 at the end of 2013. Investor B simply implemented a balanced strategy in 1994 and rebalanced back to these weightings at the beginning of each calendar year – without worrying about the 24-hour news cycle. Investor B's portfolio would be worth $43,888 at the end of 2013. The extra $2,000 cost Investor A 20 years of sleepless nights, frenzied activity and time – a high price to pay for little upside.
The long ball – whether in baseball or in investing – is exciting and dramatic. But a strikeout could not only devastate investors' portfolios but also keep them out of the market for years. This is the worst possible result because investors don't have a shot at winning unless they are in the game. The key to success: Stay in the game, and exercise self-control.
Sam Sivarajan is head of investments for Manulife Financial's private wealth business.