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John Authers: Why sitting tight is sometimes right
By John Authers
Published: February 15 2008 17:28 | Last updated: February 15 2008 17:28
Masterly inactivity has much to recommend it.
In times of extreme stress and volatility, it is a difficult strategy to maintain. Faced with the reality
of losing money, our instinct is to do something – anything – to avert it.
Dive from stocks into bonds or maybe even try out one of the nifty new exchange-traded funds
that allows you to sell the market short, and you have done at least something.
Masterly inactivity might, however, make more sense.
At one level, this is because of equities’ long-term properties. In the very long term, equities’
performance is tied to economies, and economies grow. Usually patience is rewarded. It is also
less emotionally trying than making an active attempt to time the market.
Further, there are good arguments based on “churning”. It costs money every time you make a
trade. That eats away at your investment. Leaving things as is can be very cheap. So a bias
towards inactivity makes economic sense.
Behavioural finance provides a more profound reason. Humans suffer from an activity bias.
Inactivity embarrasses us. When there are problems, our instinct is not just to stand there but to
do something.
An example from football, provided by James Montier of Société Générale, tells the story. When a
goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will
stay in the centre only 6.3 per cent of the time.
However, the penalty taker is just as likely (28.7 per cent of the time) to blast the ball straight in
front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay
where they are about a third of the time. They would make more saves. Why don’t they? Because
it is more embarrassing to stand there and watch the ball hit the back of the net than to do
something (such as dive to the right) and watch the ball hit the back of the net. The results are
the same but those who tried to be active feel happier.
This is universal. In baseball, batters often prefer to go down swinging, even when the
percentages suggest their best bet is to leave the bat on their shoulders and see if they can force
the pitcher into giving them a walk. Again, it is very embarrassing to strike out with the bat on your
shoulder.
In sport, you can capitalise on these insights. If you take a penalty, you can kick it straight in
front of you.
Similarly, in investment, there is an activity bias, which creates opportunities for those who can
resist it.
According to Montier, in experimental markets where the fundamental value of a share is clear and
where the resale of shares is prohibited, there should be no trades at prices above fundamental
value. To pay this much for a share is to buy something for more than it is worth, knowing that
there will be no “greater fool” willing to buy it from you for even more.
Instead, traders are trading out of boredom – they feel they have to do something. Like
goalkeepers and hitters at the plate, they feel they have to do something.
Moreover, the activity bias is most acute after bad results. If your portfolio is down, you feel an
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even greater need to thrash around. As it is hard, going on impossible, to time trades
successfully, this should create more opportunity for the patient.
There are arguments against this. First, timing the market may be difficult, but there is a lot of
money to be made if you can do it correctly. This has been a lousy year for equities but it has
included one rally of almost 10 per cent. Why not make at least some attempt to take advantage
of these fluctuations?
Those arguing for inactivity have a response. Why not set your portfolio to make automatic
readjustments, back to a predetermined asset allocation, once a year? If stocks have gone up
more than other asset classes, that means you will have to sell them. If they have fallen, you will
be buying more. So this disciplined approach means that, without any great agonising, you will sell
stocks when they are expensive and buy them when they are cheap.
Such mechanisms lie behind the “default” options that many think should be offered by pension
plans.
Another more timely argument is that the equity market at present is plainly in denial. Stock
investors may yet be lucky and muddle through, but the credit crisis is intensifying, banks are
cutting off the lifeblood of credit to the markets, and equities have still barely responded. Surely
anyone with a grasp of the seriousness of the crisis facing the financial sector would bail out of
stocks now?
Again, this is not necessarily so. Just ask Nouriel Roubini of New York University, who has a
reputation as the most pessimistic economist in academe. He deserves it. His most recent paper,
published last week, is entitled: “Can the Fed and Policy Makers Avoid a Systemic Financial
Meltdown? Most Likely Not.”
Nobody is more aware of the gravity of the financial situation, and nobody has done more to point
out the risks of a systemic crisis.
So how are Roubini’s own funds invested? They are 100 per cent in equities. In the long run
stocks do best and he is not yet close to retirement, so he keeps putting more money into index
funds each month.
Fully aware of the gravity of the financial situation, he is also aware of the futility of trying to take
action or to time the market. Those tempted to make the investing equivalent of a goalkeeper’s
depairing dive should take note.
john.authers@ft.com
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