Investors' Timing Decisions Linked to Higher Volatility

One investing phenomenon is the behavior gap. The behavior gap is the difference between the return of an investment and the return that investors realize. In a recently updated study, professors at Emory University and the University of British Columbia attributed this difference to the timing of investor inflows and outflows.

The authors approached the subject from the standpoint of investing strategies. If an investor buys stock X at the beginning of a period and holds it until the end of the period (e.g., five years), their return will be the same as the stock. If this investor were to add or reduce their position in the stock during the five-year period, their return would differ. As would their realized volatility.

Some of this difference in return is caused by the timing of cash flows. A person saving for retirement will make contributions (inflows) over time. A retiree will make withdrawals (outflows) over time. Even if a single investment, like a mutual fund, is invested in for the entire time, the investor’s realized return and volatility will be different than when it is measured for the fund itself if the position is added to or reduced. Good behavior, but a difference in outcome nonetheless.

Where the behavior gap becomes a concern is when it is caused by behavioral mistakes. I’ll quote from the study: “If investors tend to have bad timing in the sense of pouring capital into stocks after superior stock returns and before inferior returns (with the converse for redeeming capital), investor returns will be lower than stock returns.” It’s not just returns either. Again, quoting from the study, “investor timing can have substantial effects on the volatility of investor returns.”

Some numbers may help to put things into perspective. Holding periods were used for exchange-listed stocks from 1925 to 2018. Two strategies were used. The first is a buy-and-hold strategy. The second is a dollar-weighted (DW) strategy. The median annualized returns were 5.2% and 4.7%, respectively, over a five-year holding period. The standard deviation—a measure of volatility—was 21.9% for the buy-and-hold approach and 25.3% for the dollar-weighted strategy.

The natural inclination is to focus on the difference in returns. The difference in volatility is more notable. The dollar-weighted approach incurred 15% more volatility. Extending the period out to 10 years resulted in 25% more volatility in the dollar-weighted approach. At 20 years, the dollar-weighted approach incurred nearly 50% more volatility.

Many investors who attempt to reduce downside volatility through their buy and sell decisions end up doing the exact opposite. Their actions lead to higher realized volatility. As the authors summed up their findings: “The results for DW returns suggest that on average investors have bad timing with respect to stock volatility. They tend to ‘chase stability’ but end up being more invested during periods of high volatility, and so their returns end up being more variable than those for corresponding stock returns.”

Dollar-weighted returns are an inescapable reality for individual investors. We add to our savings, withdraw from our portfolios and change investments over time. All of this is a part of being an individual investor. Where it becomes problematic is when these decisions are made based on emotions and expectations of what might happen instead of relying on a systematic and disciplined approach to investing.