One Risk You Can Control: Bad Timing

Note: This article is part of Morningstar.com's November 2014 Risk Management Week special report.

In investing, there's a long list of events we can't control--wars, currency crises, economic stagnation, the level of interest rates--and we manage these risks as best we can through diversification. But there are a few things completely within our control, which in theory should be easier to manage. One of these is the timing of our purchases and sales.

Unfortunately, the numbers suggest that we do quite a bit of damage to our portfolios through poor timing. At Morningstar, we've been educating investors about these controllable risks for years, and our ongoing work on valuation can (we hope) arm investors with more tools to make better timing decisions.

To get a sense of the money we leave on the table through poor timing, Morningstar publishes fund-by-fund data comparing investor returns--the returns actually achieved by the average investor in a fund--versus the straightforward, as-reported return. According to Morningstar research, the typical fund investor gained 4.8% annualized over the 10 years through December 2013 versus 7.3% for the typical fund. Why is that? Mainly because, on average, investors tend to chase returns. Retail investors, financial advisors, institutional investors--we all do it. We're all hard-wired to salivate over what's going up.

To understand why we think a valuation focus is an important key to helping correct this behavior, recall this handy formula for thinking about equity returns:

Put another way, the total return of a stock is a combination of the true underlying growth in a company (represented by dividends and earnings) and a healthy dose of animal spirits (represented by changes in valuation). To correct for bad timing, the knee-jerk contrarian impulse would urge us to avoid what's gone up and buy what's gone down. And while there is merit in the skepticism implied by the contrarian stance, there's usually a very good reason an asset price has moved up or down. What we really need to worry about is the subset of investments that look questionable because of animal spirits. If you purchase an asset for too high a price, you're bound to be disappointed.

That's where our valuation tools come in. For equities, we build a valuation view one stock at a time, and we can then aggregate those bottom-up valuations to judge which pockets of the market--or even the market overall--are trading rich or cheap.

Did you really want to bail out on stocks in March 2009, when the median stock was trading at just 55% of fair value? Of course not. But a lot of people did just that, missing out on one of the great stock market rallies of the postwar era and driving another huge wedge between official fund returns and actual investor returns. Even if such valuation considerations only influence your decisions at the margin, the implications of a cheap or expensive stock market are significant. If the market is rich, those might include a slightly higher tilt toward cash or a measured approach to investing new monies in the stock market (through a drawn-out dollar-cost averaging plan, for example).

What is our valuation work telling us today? Our valuation lights are not quite flashing red, but they're not green, either. At best, they're signaling mediocre long-term returns for the stock market. Here's where we are as of this writing:

• The  Vanguard S&P 500 ETF (VOO) trades just above our estimated fair value based on the valuation of its underlying holdings.
• As of Nov. 18, only 13 stocks out of 1,000 under coverage earn 5 stars, among the lowest percentages of highly rated stocks since we launched the Morningstar Rating for stocks in 2001. (At the market low in March 2009, we had more than 600 5-star stocks.)
• The highest-quality stocks (those with wide Morningstar Economic Moat Ratings) trade near the highest valuations we've seen since we began assigning moats back in 2002.
• Morningstar investment strategists uniformly believe it's difficult to find bargains today, a sentiment echoed by many of the best investment managers we talk to.

We don't claim to have a crystal ball or think our valuations are always spot-on. But we think our Market Fair Value chart clearly shows that a bottom-up, fundamentals-driven view of valuation can provide a useful dose of corrective action: cold water in overheated markets, and a call to action in down markets.

Chart data through Nov. 18, 2014. Click chart for latest data.

Users of our equity research have seen our valuation work for some time (we launched equity ratings in 2001), and we've been gradually extending the applications of this research. Some of the other work we've already done includes:

• Calculating ETF valuations by looking through to the underlying holdings (available on Morningstar.com's  ETF Valuation Quickrank).
• Extending the valuation work of our equity analysts through quantitative techniques so that we can now place valuations on more than 40,000 stocks globally. (And that number is growing as we add companies to our equity database.)
• Within Morningstar Investment Management, we're using stock-level valuations in a number of ways. They're inputs into Stock Baskets, including the Tortoise and Hare Portfolios, as well as the Dividend Focus portfolio. And together with the Economic Moat Rating, they are the key input into the Wide Moat Focus Index, which is available to investors through multiple vehicles.

Our goal isn't to argue for getting in and out of markets based on valuation alone. In fact, our bottom-up view of the world means we think there are almost always pockets of attractively valued securities to invest in. Rather, it's to provide another lens--alongside the other tools already available--through which investors can easily judge the merits of potential investments and avoid some costly mistakes.

The empirical data show quite clearly that fund investors in aggregate already time the market and do so in a systematically bad way. What we advocate is a little corrective medicine--a nudge to better behavior and a narrowing of the gap between official returns and investor returns.

This article originally appeared in Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.