Aug 242015


Aug 24, 2015

World Class Faculty & Research


SMITH BRAIN TRUST — This week’s market selloff has made a lot of people itchy to trade stocks. They want to sell before things get worse or, alternatively, maybe pick up some bargains. David Kass, professor of the practice at the University of Maryland’s Robert H. Smith School of Business, explains why you should resist the impulse to guess where the market is headed.

Q. People who own stocks are watching the markets tumble and want to do something. Should they resist that urge?

A. The natural desire to follow the crowd — herd instinct — can be very detrimental to investment performance over the long run. For example, during the panic selling that occurred at the market open Monday, shares of many of the finest companies in the world were marked down substantially. The supply of shares being sold overwhelmed the demand from buyers. Shares of Apple (AAPL) traded as low as $92.00 soon after the market opened, a discount of 17 percent from Friday’s close of $105.76. The shares subsequently recovered a few hours later, with its price exceeding its previous close. Similarly, J.P. Morgan Chase (JPM), which closed at $63.60 on Friday, traded as low as $50.07 on Monday morning, a discount of 22 percent, before recovering virtually all of its decline. Finally, Kraft Heinz (KHZ) traded as low as $61.42 Monday morning, a 15 percent decline below its previous day’s close of $72.27, before fully recovering.

Short-term traders and market timers are more likely to have their investment decisions dictated by their emotions of fear or greed than sound judgment and analysis performed over time with long-run goals in mind. A buy-and-hold strategy is less likely to be influenced by the behavior of others.

Q. More generally — apart from unusual episodes like the ones that ended last week and began this one — is it possible to monitor the market carefully to buy low and sell high? 

A. It is extremely difficult to outperform the market over the long run by employing market-timing strategies. Predicting the movement of individual stocks or sectors over the short run is subject to risks resulting from both internal and external shocks. Unexpected events having either a positive or negative impact on an individual company, industry or sector are virtually impossible to anticipate. Major economic or political news, along with natural or man-made disasters, either domestic or international, can create substantial movements in equity prices across the entire market.

By contrast, the antithesis of market timing, which is a buy-and-hold strategy, is likely to succeed. Several academic studies have shown that equities have appreciated by about 9 percent to 10 percent (including dividends) annually over many decades. A well-diversified portfolio of stocks, or a low-cost S&P 500 index fund, such as that offered by Vanguard, should enable an investor to achieve similar returns in the future.

Q. Do market-timing strategies have any other disadvantages?

A. In addition to the challenges of forecasting short-term price movements, frequent trading will result in considerable transaction costs as well as tax liabilities.

Q. Are there any circumstances under which a market timing strategy can succeed?

A. Short-term trading strategies might depend on luck at least as much as skill. Over short periods of time, active traders might be able to outperform the market by correctly anticipating price movements. However, the randomness of events — both internal and external to individual companies — and/or sectors make it very unlikely that outperformance can be achieved over any extended time period. For example, correctly predicting the price of oil over the next few days or weeks might be possible for some, but how many traders will also be able to accurately forecast the level and direction of oil prices beyond this short-time horizon?

Q. How supportive is the academic finance literature of your views on this topic?

A. I am not aware of any academic study indicating that a short-term trading strategy results in long-term outperformance relative to a buy-and-hold strategy such as that offered by a low-cost S&P 500 index fund. The most successful investors, such as Warren Buffett of Berkshire Hathaway, have accumulated their fortunes by primarily being long-term investors. Most investors, individuals and institutions tend to invest at market tops and sell at market bottoms. This “buy high and sell low” behavior, heavily influenced by short-term market psychology, clearly results in underperformance relative to a steady buy-and-hold strategy.

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