Switching – a dangerous and costly investment strategy

Chasing better short-term returns could lead you down the wrong investment path.

Most people prefer to believe that their own skills and abilities are significantly better than average, for example, when it comes to driving their cars or even investing their money. However, due to the influence of human emotion many people are tempted to chase better short-term returns and end up making the wrong investment decisions. Investors are cautioned that shifting one’s investments between funds in an attempt to generate better returns is a very risky and most-likely, a costly exercise.

This is according to Anil Jugmohan, CFA, Investment Analyst at Nedgroup Investments, who explains that ‘switching’ as it is commonly known in the investments industry, refers to the practice of shifting one’s investments between different funds in order to generate better overall returns.

“The fundamental expectation behind switching is that the investor believes that he can consistently predict when a particular fund will produce better returns than the alternatives and thereby take advantage of this by investing or disinvesting at the appropriate time,” he says.

Jugmohan goes on to say that a common example is switching out of a fund that is currently performing poorly to a fund that is performing very well in its category. Another example is when investors move out of equity-based funds into low-risk funds after the stock market experiences a significant drop.

“However, the problem with switching out of risky investments is that at some point you have to switch back in, and many investors prefer to take the seemingly safer approach of waiting for proof of a recovery in market prices before deciding to re-invest their money. Unfortunately, by this point in the market cycle the easy money has already been made and it becomes much more difficult to achieve good inflation-beating returns with a high degree of certainty,” says Jugmohan.

He adds that it is more likely that the investment will be made closer to the peak of the market – which means that subsequent returns are likely to be disappointing. Jugmohan continues that although some investors may get lucky once in a while, it is highly unlikely that any one person can consistently get every single one of their investment calls right. “There are many factors which have a complex interaction with each other in order to produce the investment’s returns so it is unreasonable to think that these can be predicted accurately or consistently, even by the experts” he says.

At best, one can analyse the factors of valuation relating to various asset classes within the context of the drivers of these factors in order to gain a better understanding of the range of potential outcomes and future returns.

Switching as an investment strategy is not only dangerous – but costly as well. Apart from the significant taxes that may be incurred in switching from one investment to the next, there are a number of costs (both explicit and implicit) that make this strategy very difficult to profit from.

Jugmohan urges investors that once they undertake a properly structured financial plan it is critical to remain invested according to that plan in order to achieve the best results. “There are only a few reasons to completely change one’s investment strategy. These include changes to your circumstances or long-term objectives,” he says.

Jugmohan urges investors to invest based on a clear understanding of their own needs and objectives first and foremost. He concludes that this is one of the most important steps in the investment process as it is the foundation for a robust framework within which to make investment decisions.

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