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05 Jan 2016

Don't Chop And Change

The powerful emotions of greed and fear mean that it is simply human nature to chase the best returns. As a result, investors often fall into the trap of disinvesting from an underperforming fund to invest in one that outperformed over the same period. Studies abound on the folly of such an investment strategy. For example, a seminal US study showed that frequent trading eroded investor returns by up to 2.7% per annum. ADELE JANKOWITZ puts the Foord Equity Fund to the test.

Given the investability of its benchmark, the FTSE/JSE All Share Index (ALSI), and the fund’s long, 13-year history, the Foord Equity Fund is ripe for testing the effects of a “chop and change” investment strategy. Our analysis tested an alternative investment in the ALSI (investors are able to invest in any number of financial products that mirror the return of the ALSI). In these analyses, investors were assumed to have considered the return in the immediately preceding period and then invested in either the fund or the benchmark for the subsequent period depending on which had the higher ex ante return.

Several scenarios were assessed. First, a monthly strategy was followed in which the fund's return at the end of the month was compared with that of the benchmark. The investor was assumed to have “chopped and changed” based on an analysis of returns of the fund compared to the ALSI over the month. Next, we analysed the effects of applying such a trading strategy to longer periods, evaluating both one- and three-year periods.

The results were not unexpected but they did expose the extent of the foolhardiness of a "chop and change" trading strategy. Applying the monthly strategy to the Foord Equity Fund resulted in an annualised average return over the 13-year period of 18.1%, which was only marginally better than the ALSI’s 17.3% and well short of the fund’s actual 20.5% per annum return. Clearly, the trading strategy would have cost an investor 2.4% per annum for 13 years (excluding any costs associated with buying an index tracker fund).

Using a 12-month return when implementing the trading strategy, the Foord Equity Fund still returns an average of almost 1.0% per annum more than the strategy. Even more telling, simply holding the fund would have outperformed the trading strategy in 87% of rolling 12-month periods. Over a three-year period, these results are amplified: the fund exceeds the strategy's return by a little more than 1.0% per annum, but the fund outperforms the strategy in 98.6% of rolling 36-month periods. These are not odds that any rational investor should be taking.

The message is clear: investors do best to make a well-considered decision at the inception of the investment and to persist with that decision. This notion is vindicated by reams of academic literature dealing with the effects of emotion on investment choices, and, indeed, this simple empirical analysis.

As has been noted on many occasions, successful investing is not about timing the markets. It’s about spending time in the markets.

1 Source: Barber & Odean, “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment”, Quarterly Journal of Economics, 2001, pp 261 – 292


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