They need to outperform a passive, “buy and hold” strategy because they have higher transaction costs.
Active traders are by definition confident in their ability to “time” the market. They believe they have the ability to see trends early and know when to buy and sell.
But “timing” the market is notoriously difficult: short term stock movements are random and unpredictable.
If you sometimes own stock and sometimes not, you run the risk that you don’t own stock when it jumps in value.
Of course, you also have the benefit of not owning the stock when it suddenly drops.
However, these benefits do not cancel each other out, as stocks – in the aggregate – rise over time.
There is a lot of research, which shows that the hikes and drops of stock markets can be attributed to a very small number of days.
That means you will be disproportionately punished if you miss the hikes, and disproportionately rewarded if you are able to skip the drops.
An investor with a “buy and hold” strategy in the S&P500 would have received a 9.22% return per year between 1994 and 2013.
Missing the top five days with the biggest gains, would have reduced your annual return to 5.99% and missing the top 10 days with the biggest gains would have further reduced your annual returns to 4.49%.
Missing those days gets your return much closer to assets that are much less risky than stock, such as bonds and deposits.
Hence you accept the risk, but don’t get the related reward if you miss out. The impact is big, because the gains you missed, are not able to compound. (Source: https://www.ifa.com/)
Professor Nejat Seyhun from the University of Michigan calculated that 95% of all the gains of 31 years – between 1963 and 1993 – can be attributed to just 90 days.
That is only three days a year! It is quite likely that if you are an active trader, you will miss at least one of those days and do much worse than a passive investor.
Active investors – despite their intentions – are often unlucky and buy high and sell low.
An analysis on MarketWatch.com shows that the best and the worst days on the stock market tend to cluster and follow each other in rapid succession during times of above average volatility.
This makes it extremely difficult to avoid the worst days and get the best days.
Because the average return on a market portfolio is constant and positive, you can expect to lose money by trading actively, compared to a low cost “buy and hold strategy”.
People are simply terrible in predicting short term movements in the stock market.
Therefore, investing should be about “time in the market” and not about “timing the market”.
Mark Reijman is co-founder and managing director of http://www.comparehero.my/ dedicated to increasing financial literacy and helping you save time and money by comparing all credit cards, loans and broadband plans in Malaysia.
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