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Why investors need to block out short-term noise

Data tracking and monitoring have revolutionized the way we interact with the world. At the touch of your fingertips, you can access everything from your average screen time per week to the amount of calories burned on a walk. While this steady stream of data can help you improve your health, it doesn’t have the same impact in other parts of your life, particularly your money. 

For investors, there are significant drawbacks to watching your investments in real time. Investors need to understand the limitations of short-term performance data and how investors jeopardize their success by emphasizing shorter-term results. 

The consequences of amplified noise

Evaluating your performance with short-term data does little more than amplify the noise surrounding your investment decisions. This leads investors to make poor asset allocation decisions, resulting in portfolios misaligned with their risk tolerance and goals, and performance chasing, leading to high turnover and returns left on the table. 

Fortunately, through what we will call "lens shifting," investors can train themselves to resist myopic behavior in favor of a longer-term perspective, hopefully making it easier to weather short-term noise and stay the course with their investment plan. 

Should I buy stocks or bonds?

One of the first decisions an investor makes when constructing a portfolio is around asset allocation and how much to allocate to stocks versus bonds. Historically, stocks have outpaced bonds by a wide margin, albeit with much larger volatility. Most investors would expect this same dynamic to hold in their portfolios — the stock portion outperforms the bond portion. That said, if you obsess over the day to day movements of your portfolio, you could be led to a different conclusion.

Exhibit 1. Historical Frequency of SPY Outperforming AGG, September 30, 2003 to June 30, 2021

If you asked an investor who checks their account performance daily whether stocks outperform bonds, they might say that the probability is about a coin flip. On the surface, taking on equity risk isn’t worth it to them. 

However, using longer-term data, we know that investors have historically been rewarded for bearing equity risk over longer-term periods (and quite handsomely). If we allocated client money using the short-term perspective, we might find ourselves in an asset allocation that looks quite different from one informed by a longer-term perspective. 

Is my investment thesis correct?

Suppose an investor is convinced that a subset of US large cap equities are likely to outperform the broader US large cap market. For example, our investor believes that the Dow Jones Industrial Average, made up of 30 stocks, will outperform the S&P 500 Index. From January 2000 through July 2021, State Street’s DIA, a Dow Jones Industrial Average ETF, outperformed State Street’s SPY, an S&P 500 ETF, by about 50% cumulatively.

Unfortunately, when performance sharply diverges from expectations, it can cause investors to waver in their convictions. While the long term results align with our investor’s convictions, shorter time frames can lead us to different conclusions. For example, over 3-Month (63 trading day) rolling periods, an investor would have found their DIA position underperforming SPY in about 50% of the 3-Month windows. Maybe our investor can stomach smaller levels of underperformance, but what happens when the magnitude of losses increases? Our investor would have underperformed by 2% or more in about 19% of rolling 3-Month periods. 

Exhibit 2. Rolling 3-Month (63 Trading Day) Rolling Relative Performance, DIA Minus SPY, January 3, 2000 to July 30, 2021

For advisors and investors reviewing account performance quarterly, this means an investor will underperform almost once per year, on average. Without a proper perspective, an investor may convince themselves that their initial conviction might have been a mistake and that it may be time to throw in the towel and switch investments, leading to costly turnover and a constant cycle of buying high and selling low. 

This is the problem with conflating long-term expectations with short-term results; it can have detrimental effects on investment performance. Fortunately, by lens shifting, investors can realign long-term expectations with long-term results, reducing the short-term anxiety associated with checking their investment accounts more periodically and making it more likely that they stay the course on their investing journey. 

Avoiding knee-jerk reactions to short-term noise

No investor likes underperforming expectations, but they should know that short-term performance monitoring increases the probability of dissatisfaction. This is not just an exercise in understanding data, but also an exercise in understanding human behavior. In their 1997 paper ‘Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test,’ renowned behavioral economists Richard Thaler, Daniel Kahneman, Amos Tversky, and Alan Schwartz found that most people feel worse about losses than the equivalent gains, and they tend to evaluate outcomes frequently. 

According to the paper, this has two implications for investors:

  1. Investors are more willing to accept risks if they seldom monitor their investments. 

  2. Investors accept more risk when the amount gained exceeds potential losses. 

What they found was that investors who got the most frequent feedback (and thus the most information) took the least risk and earned less money. 

Simply put, the more investors look at their portfolios, the less risk they are willing to take and the less money their investments earn. 

Short-term performance evaluation can also cause investors to make knee jerk reactions about their investment strategy, forgoing their long-term plan in favor of short-term changes. Unfortunately, numerous studies have shown that this hurts investors. 

DALBAR’s annual study of investor behavior in 2015 found that investors in both equities and fixed income funds underperformed their benchmarks significantly across all periods that they studied. The study attributes this largely to ‘timing drag’, or the detrimental effects that attempting to time the market has on investment performance. Their 20-year study of mutual fund retention found that both equity and fixed income investors own their funds for less than 3.5 years, on average. Poor market timing and high turnover cause them to be left with less than if they had stuck with their long-term strategies and tuned out the short-term performance noise. 

Time and time again the market has rewarded investors with long-term, disciplined approaches. As the data showed, knee jerk reactions to short term movements only cause more harm than good in reaching your financial goals.

IMPORTANT: The projections or other information provided regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

July 15, 2022