Timing the market can cause big losses

Investors have a habit of zigging when they should have zagged, which hinders their performance. It’s a behavioural quirk that Jason Hsu, Brett Myers, and Ryan Whitby explore in Timing Poorly.

They determined that U.S. investors underperform the equity funds they invest in by calculating returns in two different ways.

First, they look at the returns reported by the funds themselves, which are called time-weighed returns. They’re equivalent to the returns generated by a buy-and-hold investor over the period in question.

Second, they calculate dollar-weighted returns, which factor in how much money investors, on average, put into the funds over time. Dollar-weighted returns better reflect the average investor experience.

A quick example helps to illustrate the difference between the two. Consider the case of a fund that gained 50% in the first year and then lost 25% in year two. It has a time-weighted total return of 12.5% over the two years (or 6.07% annually). Someone who put all their money into it at the start–and then held on until the end–did quite well.

Problem is, bad timing can turn those profits into losses. If someone put $1,000 into the fund initially and then added $10,000 more at the start of year two, they’d have lost money. The $11,000 they invested would have turned into $8,625 by the end of year two.

While the example is an extreme one, Mr. Hsu figures that U.S. fund investors earned average dollar-weighted returns of 6.87% annually from 1991 to 2013. In comparison, the funds’ time-weighted returns averaged 8.81% per year over the same period. Poor timing cost investors almost 2 percentage points per year, which is horribly bad.

But the study pointed to a group of people who fared better than average. The table below shows the results of splitting the fund universe into five equal groups by expense ratio. Investors in the lowest-fee group were able to curb their buy-high sell-low habit–at least to some degree.

It seems likely that experienced investors–who know they should stick with a good thing through thick and thin–tend to gravitate to lower-fee funds.

But, no matter the cause, low-fee funds provided investors a double bonus. They generated the best time-weighted returns and the best dollar-weighted returns. It’s another reason to buy, and hold, low-fee funds for the long term.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of June 9. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase–barring some calamity.

Notes
Price: Closing price per share
P/B: Price to Book Value Ratio
P/E: Price to Earnings Ratio
Earnings Yield: Earnings divided by Price, expressed as a percentage
Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Disclosure: Norm may own shares of some, or all, of the stocks mentioned here.)

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