We are so busy in our lives today. Decisions are made instantaneously, but knee-jerk reactions are often the wrong course of action. Taking the time to evaluate a situation can lead to a more informed decision and a better result in the long term. We are human be-ings not human do-ings; we don’t always need to be active and taking immediate action.
Quick decisions are often made because of fear. We are scared of failing or losing control. Switching away from a poorly-performing investment is a case in point, as it is human instinct to not want to suffer through poor performance.
It is very difficult to not look at short-term investment returns. During these periods many investors may be tempted to take swift action and switch out of a poorly-performing fund into a fund that has performed better. Although this may appear to be a sensible way to generate better returns, switching funds during periods of poor performance can destroy the value of your investment.
In order to switch, you have to sell your units, which will usually incur ‘friction costs’ (all the direct and indirect costs associated with a financial transaction, such as transaction fees and taxes). It also locks in the underperformance of the fund that you are switching from. At the same time, there are no guarantees that the fund that you switch into will be able to repeat its recent strong performance. By switching you are often selling and buying at exactly the wrong time.
Managing the urge to switch
There are many reasons why we switch. Next time, before we do it, it is worthwhile considering the following three factors to judge how much of a role they play in the decision making.
1. Our emotions. Market volatility is part of investing and unfortunately so is underperformance. You would not be human if this doesn’t create a sense of fear, or at least make you uncomfortable. These emotions often lead to taking action that will permanently lock in losses or missing the best time to invest.
Your role as an investor is to pick an investment such as a managed fund on the basis that it suits your needs and objectives and that you trust the fund manager – not solely on account of recent performance. If you can control your emotions, and hold on to that investment through the volatility, you have a better chance of achieving your objectives over the long term.
2. Forecasting. Driven by heavy doses of market commentary, investors often turn to macroeconomic factors to determine whether markets will deliver strong returns. However, various studies have shown there is no correlation between economic growth and share returns.
Using data from 46 countries, researchers from investment managers Vanguard found that the average equity market return over the long term of the countries with the three highest gross domestic product (GDP) growth rates was 4%. This was slightly below the average return (4.2%) of the countries with the three lowest GDP rates, despite a considerable difference between those GDP rates (8% a year versus 1.6%).
In the end, what determines the success of your investment is the price that you pay for an asset and how much return it generates for you.
3. ‘Black Swan’ events. In his 2007 book, The Black Swan, risk analyst Nassim Nicholas Taleb revived a metaphor first used by Roman poets. ‘Black swans’ are incredibly rare events that are difficult to predict and can have a major effect on markets and investments. Examples include natural disasters, or the September 11 attacks, and most recently, Brexit.
The impact on your portfolio from Black Swan events can be significant. They are highly unpredictable, however, and it is not a good idea to base your investment decisions on what could ‘possibly’ happen.
To benefit when switching funds, you have to be able to choose the best times to leave and enter the market. This is nearly impossible because markets can swing wildly from day to day in response to a variety of unpredictable factors.
Best action may be no action
Remaining invested when faced with poor performance will take strong nerves. But if you can steady your emotions and keep in mind the reasons why you invested in the first place, you can ride out a difficult period and hopefully enjoy good returns in the future. It would have been tempting to switch your investments in the final quarter of 2018 after a period of poor performance, but the S&P/ASX 300 Index was up almost 20% in the following six months.
Sometimes there are good reasons to switch. For example, if your objectives, or the fund’s objectives, change then your investment may no longer be suitable. You may have lost faith in the fund manager, or maybe you simply need to rebalance your portfolio.
Before making any decision, investing or otherwise, it is important to slow down, take time to re-evaluate the situation and focus on your long-term priorities. In today’s world the urge to take immediate action can be overwhelming, but sometimes the best course of action is to do nothing at all.
Julian Morrison is an Investment Specialist at Allan Gray Australia. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.