Does anyone ever send you articles about how the economy/stock market/world is going to collapse in the next few months? You know, a quick email like: “Hey man, I just wanted to share the infinite wisdom of this op-ed article with you so you don’t lose all your money…”
Sarcasm aside, I sometimes secretly agree with people who say the economy is due for a downturn. Years with huge losses certainly aren’t uncommon. Look at a 30-year S&P 500 graph, and you’ll see plenty of years in which market values plummeted:
Fear of the down years causes a lot of people to sit out the market and wait for a situation that seems more favorable to growth. But the timing of investments can have severe effects on overall returns, because market gains are concentrated on relatively few trading days. If an investor stayed fully invested in the S&P 500 from 1995 through 2014, they would have had a 9.85% annualized return. If that investor, by trying to time the market, missed out on just ten of the best days during that same 20-year period, their annualized returns would have collapsed to 6.1%. Even with the inevitable market downturns, investing as soon as possible is still the rational course of action to take.
Don’t Wait For Perfect Conditions: Invest In “Usual” Conditions
Even though the market sometimes takes huge hits, it “usually” increases in value. I very specifically use the word “usually,” because as investors, we thrive on the “usual.” No one knows whether the market is going to go up or down in the next year, but by correctly identifying that it “usually” goes up, we can make the most rational investment choices possible. An investor trying to make rational decisions will always need to fight against emotional reactions, which might tell us to sell when the bottom seems to be falling out of the market, or “wait it out” to see if the market is going to take a downturn. But in a consistently up-trending market, these choices make little sense, because we know that we will “usually” be wrong, and will “usually” either capitalize on losses, or miss out on gains.
The stock market has increased in value in 22 of the last 30 years. And guess what percentage of investors have consistently timed the market to take advantage of the dips and increases? .0000001%. OK, I made that number up, but think about it this way. We employ thousands of the smartest minds we can produce to analyze, manage, and invest money. They can’t even figure out what the market is going to do, so what makes you think you’re smarter than all of them? I hate to break it to you, but it’s just an impossible guessing game. Even that one time you got lucky and sold a stock at its peak doesn’t make you able to time the market—it just makes you lucky that one time. So do the rational thing, and ignore those articles, and your uncle who tells you that the P/E ratio is too high, or that “the government” is going to trash our economy. Because even if Uncle Jerry is right occasionally, he’ll be wrong most of the time, and following his advice will make you miss out on a lot of gains.
Why You Shouldn’t Trust Uncle Jerry (Or The Professionals)
Let’s take a look at 2016 for some great examples of potential market-timing decisions. (We obviously don’t want to base our investment strategy on a single year, but 2016 offers some apropos illustrations nonetheless.)
In 2016, the market took more than a 10% dip in the first two months of the year. The outlook was gloomy, and the temptation was to sell, minimize losses, and sit out what would inevitably be a rough year. There were also a ton of articles predicting a massive bear (or down) market. To put it nicely, all these people were completely and totally WRONG. In the remaining months of 2016, the market soared to end nearly 10% up for the year, and set several record highs in the process. If you had sold your positions when everyone said it was the “smart” move, you would have lost out on that 10% increase, AND realized an additional 10% loss.
In 2016, we also had the Brexit vote, where Great Britain was deciding whether to exit the European Union. Economists had all kinds of gloomy predictions of what would happen to the world’s economy if Britain left, so it was no surprise that when the vote came back in favor of leaving the EU, markets tumbled. If you’ve read the news at all, you know that the drop was very temporary, and Great Britain’s economy has been swimming along very nicely since the initial shock wore off.
One final example from here in the United States was the presidential election. Nearly all polls predicted that Clinton would win the election, so when Trump pulled out a victory, the markets reacted in shock—falling more than 5% in the hours following announcement of the results. These losses were temporary to say the least. Contrary to most “expert” predictions, after this initial shock, the markets responded favorably to Trump’s election, and ended with gains the very day after the election. And as mentioned, the rest of 2016 was nothing less than a constant party for people who did not react to the initial volatility. On the other hand, billionaire hedge fund manager George Soros pulled out of the market, and even bought options predicting that the market would crash after Trump’s election, only to realize his mistake a few months later—a mistake that literally cost him a billion dollars.
But what if Soros had been right? I say, what if he had been right? We’re not hedge fund managers. We’re regular people who keep our money invested over long time horizons. Even if the market dips, it will come back. Since its inception in 1928, even considering the worst financial events in our history (including the Great Depression, the dot-com bust, the 2008 housing crisis, etc.), the S&P 500 has still returned about 7% per year, adjusted for inflation. Unless emotion is guiding a person’s investment decisions, there’s really no reason to give up a 7% average return by trying to time the market.
But won’t you feel really dumb if you invest a lot of money now, and the market drops next year?
Consistent investing, and resisting the urge to time the market, results in a phenomenon known as “dollar cost averaging.” In simple terms, this means that as you invest your money over time (ignoring other people’s efforts to time the market), you have the opportunity to buy equity in the market at all different price points. Sometimes you buy “high,” which means you don’t get as many shares for your money, and sometimes you buy low, which means you get more shares for the same amount of money. Taken together, you end up buying at roughly the average market price over the time you invested. This means that even if you invest today, and the market drops tomorrow, as long as you keep investing, the loss from today’s investment will average out, and you’ll end up making money.
Dollar cost averaging actually is not the optimal way to make gains in the stock market. Remember when I said that the market generally goes up? Well that same principle applies here, and means that as time goes on, the “average” price of the market increases as well. If you had the option of investing your life-savings at any point in time (including by spreading those investments out over your entire lifetime), the best time to invest everything would probably have been the day you were born. However, we don’t have that option, and most of us invest money as we receive paychecks. So although we have to settle for less-than-optimal returns, we still have the benefit of decreased volatility through dollar cost averaging—think of it as a silver lining.
How I Time My Investments
Although we can’t go back in time to invest our life-savings, we are faced with timing decisions on a micro level all the time. We may get a bonus from work, sell an old guitar, or simply look at our potential investments for the upcoming year and wonder how best to proceed. Because these decisions happen throughout our lifetime (or at least over the years that we are working toward financial independence), the best choice is almost always to invest as much money as possible, as soon as possible. Sometimes the market may spiral downwards right after we invest, but usually, it won’t. If you stick to your guns (and diversify well), you will win more often than not.
If you are faced with a truly once-in-a-lifetime investment decision—say a large inheritance—you might understandably be nervous to invest everything all at once. If you are, go ahead and evenly space the investment out over 6-12 months (i.e., invest 1/6th or 1/12 of the total sum each month until it’s gone). Although you will likely end up making slightly less overall, you will offer yourself a degree of protection from an extreme drop in the market. But most investment decisions are not nearly as significant as this, and you are probably safe (and better off) investing any money you can immediately.
Even though I’ve spent this entire post telling you about how market timing downsizes gains, there are some ways to make market timing work in our favor. First, as I mentioned, if you receive a bonus, or moderately sized lump sum, invest it immediately. The fact that you’ll likely invest money at some point in the future severely cuts down your risk of a pending market downturn. If the market takes a downturn right after you invest your bonus, you’ll have next year to average out the loss, and probably the year after that.
Another strategy you can use is to invest as much money as you can spare, as early in the year as possible, in your retirement account. Find out if your employer allows you to front-load your 401k contributions towards the beginning of the year (without, for example, reducing the employer match), and invest as much as possible until you hit the yearly contribution limit (even if this means reducing other taxable investments during this time). This provides several benefits. First, if the money is taken out pre-tax, you’re deferring your taxes for as long as possible, which allows your investments longer to grow and compound tax-free. You also hedge your bets by taking advantage of the tax benefits early in the year. If you lose your job, or even if you decide to retire early, you’ve already contributed as much to your retirement account as possible for that year. Of course, as we’ve been talking about, the main advantage is that you give your tax-favored investments more exposure to a market that consistently up-trends, which means you will likely have higher gains over time.
Finally, I’ll give you my single exception to the rule against “timing” the market. When the market takes a substantial dip (say 5% or more), I sometimes try to take advantage of this volatility by investing any extra money that I can spare. I would not recommend changing your normal investment schedule (and certainly don’t hold back any money you would usually invest to wait for the inevitable dips), but this strategy can provide a bit of a nudge to help boost your overall gains during the year.
Hopefully this helps clarify why I still believe it’s a good idea to invest in all market conditions, and provides a few of the practical strategies that I use for my own portfolio. Comment below and let me know what other strategies you use to make alpha returns, and how you resist the urge to time the market!