Investing in Times of a Pandemic

Every year around this time, Schroders releases its Global Investor Study, a survey where the British asset management company analyzes the attitudes and behaviors of 23,000 investors from 32 countries. Naturally, this year’s survey revolves around how the pandemic has affected the investment decisions and economic prospects of investors.

According to the Global Investor Study, when the coronavirus pandemic hit the markets in the first quarter of the year, almost 80% of investors decided to restructure their investment portfolios in order to minimize financial losses. Advanced investors were more likely to implement substantial changes in their portfolios: 88% of investors with significant financial knowledge restructured their portfolios, whereas only 57% of those who have little financial knowledge did so.

This seems to make sense. Expert investors are better equipped with the theoretical tools and experience to make informed decisions regarding their portfolios, which in turn should allow them to minimize losses in times of economic distress and outperform non-expert investors during bull markets. But does this commonsense idea fit the evidence? Are financial experts better than the average investor in maximizing portfolio returns?

Not really. The literature suggests that active portfolio managers (i.e., professional asset managers that make frequent adjustments to their clients’ portfolios) systematically underperform stock market indexes. In other words, the more you mess around with your portfolio, the more likely you end up losing money. And this is true even if we factor out the negative influence on returns of the large management fees charged by active asset managers.

The curse of active management is also applicable to financially literate investors who manage their own portfolios:  frequent security trading tends to undermine long-term portfolio returns. But how come financial literacy doesn’t lead to more efficient portfolio management and thus higher returns? After all, as I argued in a recent AEC article, financial knowledge empowers people, helping them make more informed decisions regarding where to invest their money.

The answer to this question is closely linked to what Hayek called fatal conceit, i.e., the dangerous idea that experts can control what’s actually beyond their control. In the case of portfolio management, this fatal conceit stems from the chimera that investors can time the market. In effect, most investors believe that they can confidently predict booms and busts in financial markets, which leads them to buy or sell in anticipation of future market rallies or crashes. This explains why a large fraction of investors restructured their portfolios as a response to the pandemic.

Unfortunately for them, Nobel-awarded economist Eugene Fama showed four decades ago that financial markets are mostly efficient, an idea that has two corollaries. First, stock price movements are unpredictable, which means that trying to time the market is just a fool’s errand. Second, most investors trying to beat the market (i.e., achieve higher returns that a comparable stock market index) via frequent portfolio adjustments will fail to do so. Consequently, in the long term, market timing only leads to lower returns.

The pandemic-induced financial shock is a good example of the foolishness of market timing. If you tried to time the market in late March and sold your U.S. stocks in fear of further losses, you missed the rally that led the S&P 500 to recover its pre-pandemic level in only six months, with the subsequent negative impact on your returns. Maybe you cashed out right before the crash and got back in the market when the rally started, but don’t count on being so lucky next time.

Financial literacy is essential when it comes to investing one’s money. After all, if you want to build you own portfolio, you need to know, among other things, the different risk-reward characteristics of stocks and bonds. However, this isn’t enough. Financial knowledge needs to be accompanied by the humility to acknowledge that beating the market is extremely difficult in a given year and impossible over a long period of time.

Therefore, regardless of whether you’re a rookie or an expert investor, don’t waste your time and money trying to time the market. Instead, build a diversified portfolio you’re comfortable with in terms of risk (preferably using low-cost index funds or ETFs) and leave it there. You may have to adjust it as you get older and your risk tolerance decreases or rebalance it once in a while to maintain your original weightings, but avoid frequent trading in search of higher returns. Your future self will thank you for it.