The High Cost of False Apocalypses

Over the years, some of the biggest losses to investors have arisen from market calamities that never happened. This may sound paradoxical, yet it’s a fact. The explanation is that many more apocalypses are prophesied by financial commentators than actually occur. That contributes to the excessive trading that leads to significant underperformance.

A Catalogue of Recent Non-Catastrophes

Just in the past ten years, numerous events have triggered fears of economic and financial catastrophe but instead turned out to be at worst modest, temporary setbacks. Here are some examples:

·       Brexit (2016)

·       Election of Donald Trump (2016)

·       U.S.-China Trade War (2018)

·       Fed Tightening (2018)

·       Inverted Treasury Yield Curve (2019)

·       COVID-19 Pandemic (2020)

·       Evergrande Default (2021)

·       Russia-Ukraine War (2022) 

Source: Bloomberg Professional Services and Verified ChatGPT

Reacting to Every Predicted Crisis Is Costly

Any one of the abovementioned false crises could have induced investors to derisk or even liquidate their portfolios and go to cash until the expected crisis passed. Such reactions would have inflicted avoidable transaction costs. That would be true even in a zero-commission setting, due to bid-asked trading differentials.

Moreover, the security sales would have occurred at temporarily depressed prices, with a strong likelihood that reentry would not occur until after prices had already begun to recover. On top of those trading losses, capital gains taxes might have resulted from selling low-cost-basis holdings.  In short, investors who reacted to multiple warnings of major selloffs that never happened would have taken large hits to their performance.

Overhauling one’s portfolio in anticipation of calamitous declines that never come to pass contributes to the overtrading that heavily penalizes long-run returns. This effect is well documented in financial research.  For example,  Brad M. Barber and Terrance Odean^[1] examined 66,465 accounts at a large U.S. discount brokerage and found that households with the highest turnover earned substantially lower returns than those that traded least. The annual Quantitative Analysis of Investor Behavior report by the market research and auditing firm DALBAR consistently shows that investors tend to buy after strong performance and sell after declines, with frequent switching among funds lowering their realized returns.

Do not conclude from this discussion that it’s never appropriate to alter a portfolio’s risk profile, even if that means incurring transaction costs and, possibly, adverse tax consequences. It’s correct, though, to aim at revising your strategy only in light of secular, rather than cyclical changes. Selling partway into a temporary decline and buying after the rebound has already begun is clearly less optimal than standing pat through an ordinary market fluctuation, as you may deduct from the table below.

Source: Bloomberg Professional Services and Verified ChatGPT

Keep in mind that professional pundits gain less notice by saying, “This, too, shall pass,” than by portraying a bump in the road as an existential crisis. They have an incentive to push people’s buttons in ways that are likely to induce overreactions. 

If you make sure that your buttons aren’t the ones being pushed, you’ll avoid excessive portfolio turnover that - and this is predictable with high confidence - will cause you to wind up with less wealth than you could have accumulated by maintaining a long-term focus.

^[1] Barber, B. M., & Odean, T. (2000). Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.219228