In case you haven’t noticed, the stock market has been rallying aggressively over the last three months, with the S&P 500 Index posting new all-time highs on what seems to be a daily basis. Still, as markets reach new highs, it’s unlikely that actual investors are seeing the same results.
There are both good reasons and bad reasons to be lagging a rising equity market. Here are some of the common culprits. (For more, see: Is Your Portfolio Beating Its Benchmark?)
Reason 1: You’ve Sat on the Sidelines
Less than 10 years after the start of the subprime crisis and the housing market meltdown, the recession that followed and the accompanying implosion of stock prices might as well be a thing of the past. Yet the memory of such a prolific decline is still fresh in many investors’ memories. Hesitance to reinvest hard-earned savings and holding onto large cash positions is a pretty common thread. While this may feel safe, it’s not without its own set of risks.
Simply put, cash yields essentially no nominal return and negative real returns in an inflationary environment. While investing in securities does lend itself to fluctuations in asset prices, investors would be wise to remember that not investing at all carries its own purchasing power risk.
Reason 2: You’re Not Completely Invested in U.S. Stocks
Asset allocation is the most important decision an investor makes. Modern Portfolio Theory suggests that diversification into many asset classes may decrease volatility in a portfolio, while providing attractive risk-adjusted return potential. While this diversification is valuable, not all asset classes held in a portfolio move in tandem with one another (nor should they, typically). So when one is performing well the others may not.
There can be a tendency to focus on the parts of a portfolio that have underperformed, while forgetting that those holdings may serve a purpose in relation to the rest of the portfolio. Humans are susceptible to hindsight bias, which causes them to feel like they knew something that happened in the past was going to happen. This may breed reactions to performance like: “I knew the market was going to go up, I should have been fully invested in stocks.” Understanding this bias is key to avoiding a major shift in asset allocation, aka strategy, at an inopportune time.
It’s important for investors to recall that if all assets in a portfolio were performing well in an upturn, the opposite may be true in a downturn.
Reason 3: You’re Trying to Time the Market
When compared to today’s investor, no populous has ever had both the breadth and constant exposure to news. For the next “doomsday” story or “hot investment idea” look no further than your Facebook or Twitter feed - not to mention the financial news. (For more, see: Market Timing Fails As a Money Maker.)
Many of these stories are very compelling and can motivate investors to act. Unfortunately, very few analysts have been made famous by making a prediction with a tone of "uncertainty runs rampant, investors should do nothing." However, this can often be the best advice.
To analyze how impractical market timing is, let’s just say that a successful market-timer is right on 70% of their guesses (er, I mean, predictions). In order to time a decline and reinvestment, they must get both the sell and subsequent buy right. The combined probability of stringing these two together is a paltry 49% or basically a coin flip. This is a lot of stress, and transaction costs, to take on for a similar success rate to that of tails.
Fortunately, there are many factors investors can control on their own including limiting costs, making new additions to the portfolio, diversification, etc. Moving energy to these places has a good chance of making a positive impact, while stressing about market movements is like sitting in a rocking chair - it will give you something to do while you sit but it won’t help you get anywhere.
Reason 4: Fees are Hurting Your Performance
Some costs to investing are unavoidable, but reasonable. Trading fees, fund expense ratios and advisory fees are all justifiable up to a point. However, too often investors’ performance can be impeded by unnecessary expenses like mutual fund loads, large and outdated investment advisory fees, and sizeable expense ratios on funds that make big promises about the benefits of active management.
Be sure to screen through the expenses you’re paying to ensure your dollars are being well spent.
Some of the above represent good reasons to lag and some represent bad ones. In any case, make sure it’s understood why then make sure that education is carried forward to help improve your portfolio and, ultimately, lead to a better investment experience. (For more from this author, see: Inherited IRA Distributions and Taxes: Getting it Right.)