Researchers have amassed plenty of persuasive evidence in recent years showing that market timing—or moving in and out of stocks based on where you think the market is headed—often leads to lower returns.
But if that isn’t enough to convince you, perhaps this will: A new study finds that active trading also significantly increases the volatility of a portfolio. That is, market timers actually assume much more risk to get those lower returns, compared with investors who simply buy and hold investments.
These findings are timely, following a year in which the stock market took investors on a wild ride, plunging into a bear market early on and then surging to record highs at year’s end. Over the same time, digital apps that encourage Americans to engage in active trading strategies also experienced explosive growth as new investors—some likely stuck at home because of the pandemic and seeking new thrills—crowded into the market.
So as we enter a new year, and investors are forced to deal with a future full of uncertainty, it is worth looking at this new study from Ilia Dichev of Emory University and Xin Zheng of University of British Columbia that explores the connection between active trading and risk.
Although active investors tend to “chase stability”—they are trying to minimize volatility by market timing—they end up doing the exact opposite, according to the research, as they invest in stocks after past volatility is low and before future volatility is high. The end result is high capital exposure when volatility is increasing. In particular, Drs. Dichev and Zheng find that “the volatility of the actual investor experience is nearly 50% higher than the corresponding volatility of stock returns.”
