How to avoid wiping out your equity gains

With high levels of uncertainty both globally and in South Africa keeping market volatility high this year, it’s important for equity investors to recognise that they could be their own worst enemies if they decide to sell out of the market or switch to a different investment after a substantial downturn. By doing this they risk erasing valuable long-term gains they have built up, and not benefiting fully from their existing investment strategy. 

Over the long term, it has been shown that most investors are not reaping the full benefit of their equity returns. 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% p.a. over 30 years (1985-2014), compared to 11.06% p.a. from the US S&P 500 Index, an enormous 7.27 percentage point difference per year. To put this in perspective, an additional 7% p.a. return over 30 years would give an investor seven times more capital.

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 did typically choose 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.

It is no coincidence that the four “bad” years were those in which there were extreme market falls, such as 2008 and 2002, which led to irrational investor behaviour. This highlights how just a few moments of panic (a very human reaction) 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, too short of a period to be able to benefit fully from equity market returns, since the market moves in cycles (and equity fund manager performance also generally does). With investors switching out of their equity funds nearly every three years, it’s not surprising that the return they receive is far more dependent on their own behaviour than on fund performance.   

So how can investors improve their own returns in 2016 and beyond? Obviously, they must avoid panicking and selling out of their equity investments in downturns. 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 (both positive and negative), over periods of five years and more this range narrows considerably, and the probability of any negative return outcome falls significantly.