The approaching first anniversary of the bull market that began in October 2022 presents an occasion to revisit an age-old question in investing: Does frequent monitoring of investment portfolios lead to better results?
To answer this question, let’s imagine a scenario where Rip van Winkle fell asleep one year ago, just before the bull market started. If he were to wake up today and check the stock market’s performance, he would see a 17.6% total return on the S&P 500. Rip would likely yawn, fall back asleep with a contented smile, and be pleased with his double-digit gain.
Now, consider someone who checks their portfolio value several times per month, if not more frequently. With recent fluctuations causing the S&P 500 to trade as much as 6.9% below its bull-market high this past summer, this frequent checker would likely be anxious and worried. Instead of focusing on their double-digit gain over the past year, they would be fixated on the two-month 6.9% loss. This anxiousness might lead them to have lower equity exposure, which, in turn, may result in lower long-term performance.
To illustrate this phenomenon further, let’s imagine a Rip van Winkle who fell asleep five years ago, completely unaware of the intervening global pandemic, geopolitical events, and celebrity headlines. If he were to wake up today, he would see that the S&P 500 had produced an annualized five-year total return of 10.0%. Once again, he would fall back into a peaceful sleep, undisturbed by the short-term market ups and downs.
It’s important to note that these illustrations can work in reverse as well. At the end of last year, for example, the stock market was sitting on a trailing-year loss and a trailing two-month gain. However, even in such cases, the frequent checker would tend to have lower equity exposure than Rip van Winkle due to experiencing the stock market as more volatile.
To further demonstrate the impact of monitoring short-term returns, let’s consider a real-world experiment. In 2010, Israel implemented a regulation that prevented mutual funds from reporting returns over periods shorter than 12 months. Prior to this change, investors received statements with shorter-term returns. The post-regulation environment resulted in investors perceiving funds to be less volatile and less risky.
A 2017 study by Maya Shaton, an assistant professor at Ben-Gurion University, examined the impact of this regulation on investor behavior. The study found that investors’ behavior indeed changed significantly after the new regulation went into effect. There was a reduction in fund flow sensitivity to past returns, a decline in trade volume, and increased allocation to riskier funds.
While the investment implications may suggest avoiding looking at short-term performance altogether, this is unrealistic for most investors. It is nearly impossible for anyone following the news not to notice how the markets are doing, as economic news frequently appears on the front page nowadays.
A more realistic strategy is to put guardrails on portfolios to prevent impulsive changes based on short-term market movements. One approach, recommended by the late Harry Browne, is to divide investible assets into two portfolios: a speculative one and a permanent one. The speculative portfolio, consisting of a small fraction of the assets, allows investors to react to every short-term development in the markets. The bulk of the assets would be held in the permanent portfolio, invested in index funds for the long term with minimal changes apart from periodic rebalancing.
This division into two portfolios is psychologically realistic, as it allows investors to indulge their short-term focus while being protected from potential damages by the long-term outperformance of the permanent portfolio.
In conclusion, the frequent monitoring of investment portfolios can lead to heightened anxiety and lower long-term performance. While it may be challenging to completely avoid paying attention to short-term returns, implementing strategies like dividing assets into two portfolios can help mitigate the negative impact of frequent checking. It’s crucial to understand the psychological biases at play and take steps to protect one’s long-term investment goals.