It's easy to talk about ignoring short-term market events and to recommend focusing your attention on the market’s long history of positive returns. It's another thing entirely to sit through the daily volatility of the market, watching your account values jump around, without succumbing to the temptation to trade your portfolio holdings. The urge to trade isn’t just about avoiding potential losses. For many people, the stock market is a place of opportunity to make money quickly. But according to a growing body of research, it’s the investors who take a long view of the market and employ a systematic approach to investing who achieve the most investment success.
This difference in long-term performance is one reason why it’s important to draw a distinction between trading and investing, and to be aware of which type of behavior you’re engaged in when you enter or exit the market. Investors typically own shares in a variety of stocks and stock indexes with the hope of participating in the future growth of the companies they own. In some cases they may also receive dividend payments along the way. Traders, on the other hand, are more concerned with profiting by accurately predicting the short-term factors that may affect a stock’s price.
Kevin Kelly, CFA, wrote a white paper recently about the efficiency of the markets and the difficulty that traders and active portfolio managers experience when it comes to consistently picking winning and losing investments. In the paper, he cites several research findings of the famed economist Eugene Fama. One of those findings is that portfolio design, including broad diversification, is the most important component of long-term investing success, not market timing or an ability to pick stocks.
Fama maintains that markets are highly efficient and that all available information is quickly incorporated into the price of stocks. As a result, attempting to consistently pick securities that will outperform the broader markets may only serve as a way to reduce your potential for return. And the transaction costs and tax impacts of a portfolio with higher turnover rates may further compound that reduced potential.
Kelly's paper also highlights two famous mutual fund managers, Peter Lynch of Fidelity Investments and Bill Miller of Legg Mason. Both managers had periods during which they consistently outperformed the S&P 500 benchmark, perhaps leading investors to believe that stock picking and market timing by professionals could produce superior investment returns. However, both managers ultimately experienced long periods of underperformance, which raises questions about the ability of investors to consistently outperform the broader markets. Doing so, it seems, requires a great deal of vigilance and no small amount of luck.
But when you don’t attempt to pick hot stocks or predict day-to-day price movements, time and the power of compounding gains become your best friends. Further, a broadly diversified portfolio should help to reduce volatility and increase exposure to at least some parts of the market that experience growth. Even if your risk tolerance and time frame necessitate a more conservative approach, e.g., including more exposure to bonds, the same rules of diversification apply.
When it comes time to add funds to your portfolio, you may be concerned about the timing of new deposits. One possible fix for this may be to implement an automatic investing strategy. If you know that your portfolio will receive a deposit from your bank account at the start of each month, and that it will be invested according to your carefully built asset allocation, that might reduce the temptation to trade. It will also ensure that you are adding to your holdings at random prices and not trying to time your investment. Once your system is on autopilot, your primary job as an investor may be to sit back and rely on history to do the work for you.
 Kelly, Kevin, "Market Efficiency and the Value of Portfolio Design." SJS Investment Services. July, 2014.
 Fama, Eugene F., and Kenneth R. French. October, 2010. Luck versus Skill in the Cross-Section of Mutual Fund Returns. Journal of Finance 65, no. 5.