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How to avoid selling stocks at the wrong time

(MoneyWatch) The winning strategy for investors is simple: Build a globally diversified portfolio using low-cost, passively managed funds, such as index funds, and stay the course, re-balancing and tax managing along the way.

The problem is that while the strategy is simple, it isn't easy. To follow it, you have to control emotions like fear and panic, which can cause you to abandon your plan.

The evidence is very clear that investors tend to increase their allocations to stocks after periods of strong performance (when they think the all-clear signal is out). And they tend to lower their allocations to stocks after periods of poor performance. This leads to a buy-high and sell-low strategy, and it also explains why many investors underperform their own mutual funds.

The "lost decade" from 2000-09, when the S&P 500 Index lost about 1 percent a year, provided the latest example of this pattern. After the market crash in 2008, individual investors withdrew hundreds of billions of dollars from stock funds and moved them into safer bond funds. The result was that those dollars missed out on the ensuing rally, as stocks returned more than 100 percent.

In his book "Market Sense and Nonsense," author Jack Schwager showed that the best time to be in stocks has historically been after periods of poor performance. Schwager examined the returns of the S&P 500 for the period 1871-2011. When the index had a year of returns ranking in the bottom 25 percent of years, the market rose 12.4 percent the following year. After years of top quartile performance, the index rose 10.8 percent.

The gap actually widens as you get farther away. The return three years after bottom-quartile performance averaged 12.9 percent, versus 9.9 percent three years after top-quartile performance. The same exercise five years afterwards yielded returns of 18.7 percent after bottom-quartile performance, versus 9.4 percent after top-quartile performance.

What many investors seem to fail to understand is that after periods of relatively poor performance, stock valuations are relatively low. Thus, expected returns are relatively high, and vice versa.

The takeaway is that the best time to start a long-term investment plan is after a prolonged period of relatively poor performance, such as the lost decade. And the worst time is when investors are most enthusiastic about stocks, such as 1999. In other words, just when investment discipline is needed most, investors tend to lose discipline.

Image courtesy of Flickr user 401(K) 2012

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