As we already saw in other articles, investors should behave as if stock prices are always correct. Not even professional fund managers can buy stocks at a "low" price and sell at a "high" price. On average, mutual funds underperform simple market indexes (e.g. S&P 500) without even accounting for their high fees. Moreover, fund investors underperform their own funds in the majority of the cases (Dalbar, 2014). This happens specifically because of timing. It is impossible to know when the market is at its peak or its nadir. Amateur investors, especially, tend to buy stocks at the worst possible time and sell at the worst possible time. In other words, mutual funds underperform the simple market and amateur investors underperform the funds.
In 1992, for example, investors were allocating 58% of their assets in stocks and by the Dot-com Bubble of 2000, this number had increased to 74%. In the two years following the peak of the Dot-com Crisis, the average investor allocation in stocks had dropped to 54%. Therefore, their market timing was horrible. Investors were investing heavily in the market peak and selling their shares on the market's nadir (Thaler and Sunstein, 2008). Similarly, in the same study, in 1998 only 12% of the individuals invested in tech companies. In 2000, this number had already increased to 37%. After the crisis, the number of investors in tech firms had returned to 18%. Moreover, the crisis was named, the Dot-com bubble, for a reason. The price drops were focused exactly on technology companies. The Nasdaq index, which focuses on tech firms, lost 78% of its value from March 2000 to October 2002.
Why does that happens? That is, why people invest so badly? A myriad of factors causes bad investment decisions. One of them is that people are highly influenced by society, i.e. herd behavior. It is very hard for most individuals to go against something when most of their friends, family, and their social circle, is telling to do so. Humans, to some extent, see the behavior of others as an indication of what is right. If most of the people are saying so, it should be right (e.g. Deustch and Gerard, 1955). Individuals also associate past behavior (like prices going up for years) as a solid reason to believe that this behavior will continue (like prices will continue to go up), without paying enough attention to why this trend should resume. This phenomenon is widely known in academic circles and called representativeness heuristic (e.g. Tversky and Kahneman, 1974). Moreover, humans also dislike to lose 2 times more than they like to win (Thaler and Sunstein, 2008), and mainstream media also helps to spread misbehavior since bad news (market crashes) sells much better than good news.
Mainstream Financial News Interviewer: What do you recommend people do at times like this when they wake up and see that their stock may be falling [...]?
Richard Thaler (The 2017 Nobel Laureate): Turn your [TV] off. The more you pay attention, the more trouble you are going to get yourself into.
Buying stocks when prices fall abruptly is also a bad idea. Markets are efficient enough that one cannot buy stocks at a “low” price and sell at a “high” in order to consistently beat the market. You can do it once or twice and earn more than the market due to luck since markets are random, i.e. the chance the market will go up tomorrow is about 50%, the chance it will go down is about 50%. However, as you keep trying to buy stocks at a “low” price and sell at a “high” your odds of being underperformed by the market also keeps increasing. In a sense, the stock exchange in the short term is like casino roulette. You can spin the roulette 1, 2, 3, 4 times and win money on all of them. However, if you keep spinning the roulette wheel for long periods of time your chance of losing money (or earning less than the simple market index) is basically 100%. As evidence of that professional fund managers underperform the simple market index and the majority of the day traders suffer financial losses (Siegel, 1994). Dr. Kate Waldock, Professor of Finance at Georgetown University, explains why this happens well by using the recent coronavirus sell-off as an example:
“A lot of people are speculating about whether this is a good time to buy the stock market or start buying stocks because prices have gone down by a lot [30%+ drop] in the past couple days [including the largest daily drop in 30 years and several circuit breakers around the world].
First of all, this is extremely ill-advised and irresponsible when you should understand that if you do decide to pursue this sort of investment strategy you are essentially just gambling what is going to happen with coronavirus. And unless you're an epidemiologist but even if you are epidemiologist it's impossible for anyone to predict how this is going to continue to affect markets going forward. [...] This is a strategy called “catching the falling knife” for a good reason. It's not a strategy that anyone ever encourages, at least not anyone with any sound financial experience.
And then, finally, think about when Bear Stearns [Bank] collapsed. That was in March of 2008. There was still 6 months before Lehman Brothers collapsed [i.e. the beginning of the 2008 Crisis]. There was a sell-off at the time of Bear [Stearns collapsed] but that doesn't mean it was a good time to invest in markets. Look, I hope that the markets don't get a lot worse from where they are today, but who knows? There is a possibility that this can continue going on for quite a long time.”
How should one invest in stocks then? You should buy stocks (i.e. total market index or ETF) as investments of 10+ years whenever you have the money available, regardless of the market, and forget about them. As we already saw in Stocks vs. Bonds Investments, the greatest peaks in the stock market of the 20th century were in 1929 and 1966. However, even in that scenario, if an investor had allocated the same amount of capital in these years in bonds and stocks, their stock investments would have outperformed bonds by more than 600% since 1929 and more than 300% since 1966. Long term investors should always prefer to buy stocks rather than buying bonds or leaving money parked in their bank account, regardless of how high the stock market seems to be.
- Dalbar (2014). “Quantitative Analysis of Investor Behavior." Advisor ‘Free Look’.
- Deutsch, Morton, and Harold B. Gerard (1955). “A Study of Normative and Informational Social Influences upon Individual Judgment.” Journal of Abnormal and Social Psychology, 51: 629–36.
- Kahneman, Daniel, Jack L. Knetsch, and Richard H. Thaler (1991). “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias.” Journal of Economic Perspectives 5, no. 1: 193–206.
- Siegel, Jeremy (1994). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.
- Thaler, Richard H., and Sunstein, Cass R. (2008). Nudge: Improving Decisions About Health, Wealth, And Happiness. New Haven: Yale University Press.
- Tversky, Amos & Kahneman, Daniel (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131
- Kate Waldock and Luigi Zingales. The Capitalisn't of Coronavirus. Capitalisn't Podcast
- Richard Thaler: Here's the best investing strategy. MarketWatch Interview
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.