Solving the puzzle of longevity in the market

With high levels of uncertainty, both globally and in South Africa, which are likely to keep market volatility elevated in 2016, it is important for equity investors to recognise that they could be their own worst enemy.

This is a threat if they decide to sell out of the equity market or switch to a different investment after a substantial downturn. By doing this, they risk erasing the valuable long-term gains they have built up over time, and not benefiting fully from their existing investment strategy.

No full benefits here

It has been shown that most investors are definitely not reaping the full benefits of equity markets over the long term. An eye-opening study covering the entire US mutual fund industry, Dalbar’s Quantitative Analysis of Investor Behaviour, has demonstrated how the average US equity investor experienced a return of only 3.79% per annum over 30 years (1985-2014), compared to 11.06% per annum from the US S&P 500 Index, an enormous 7.27 percentage point difference per annum.

To put this in perspective, an additional 7% per annum return over 30 years would give an investor seven times more capital.

Why the huge difference?

Why this huge difference? The Dalbar study found that it had little to do with which equity unit trust - or fund manager or ETF - the investor had chosen. Rather, it was due to panic.

During downturns, investors switched out of their equity funds and into other assets (equity or other types), that were seemingly better-performing. In 16 out of the 20 years studied, they typically chose a sound alternative.

However, in the four years in which they were wrong, they got it badly wrong, wiping out all of the previous years’ gains and more.

Acting irrationally

It is no coincidence that the four bad years were those in which there were extreme market falls - such as those in 2002 and 2008 - which led to irrational investor behaviour. This highlights how just a few moments of panic can wipe out many years of hard-won returns.

In fact, Dalbar found that investors only stay invested in an equity fund for an average of 3.3 years. This is too short of a period to be able to benefit fully from equity market returns, since the market moves in cycles. Equity fund manager performance also typically shows value on a cyclical basis.

With investors switching out of their selected equity unit trusts nearly every three years, it is not surprising that the return they receive is far more dependent on their own behaviour than on fund performance.

Improving returns

So how can investors improve their own returns outcome in 2016 and beyond?
Obviously they must avoid panicking and selling out of their equity investments in downturns. However, it is not easy to fight against human nature. To help avoid this, it’s important that investors’ expectations are correctly managed upfront, before they invest in equities.

One way to do this is to ensure they understand likely market volatility: since 1928 the US S&P 500 Index has experienced market downturns of 5% or more an average of 3.4 times per annum (according to S&P, BofA Merrill Lynch).

Another powerful tool for managing equity volatility is to have an investment time horizon of at least five years. While over only one year there can be a very wide range of outcomes for equity returns, over periods of five years and more, this range narrows considerably, and the probability of any negative return outcome falls significantly.

Financial advisers can also play an important role by managing clients’ expectations and helping them stick to a personalised long-term financial plan. Their value added from choosing an appropriate fund manager or even structuring a portfolio is secondary. Prudential has long advocated the benefits of using a financial adviser, and the Dalbar data on the actual investor experience show why.