Market volatility and trading volumes reached new levels recently. Here’s our take: Making smart, confident investing decisions means having a plan — not just in the coming days but for the long term.
Market Timing: Does It Work?
Many people have the temptation to time the market — they want to wait for the bottom, and then sell when things recover. But let’s take a moment to talk about why this isn’t a good idea.
As we wrote in this blog post about the myths of market timing (aka active management), those who believe in this approach are basically trying to decide whether it’s better to invest now or later, and are thereby making an active market call. And this has become a popular trend as the financial media is obsessed with market timing.
For good reason, people want to hear about a hot new stock tip, not a boring buy-and-hold strategy. Unfortunately, this creates the illusion that anybody can go out and pick the best stock or call the next market peak — or at least profit by investing with those who can (e.g. investing in actively managed mutual funds).
This leaves the obvious question: Does market timing work? Maybe for a select few, but even these individuals can’t get it right every time. And it just takes one bad call to erase all your previous gains. Take Bill Miller, for example, who ran the famous Legg Mason Value Fund (LMVTX). Going back to 1993 (a ~20 year period), this fund outperformed the S&P 500 for 13 straight years through 2005. He was hailed by many as a genius. And then it all fell apart. Due to some poor portfolio bets, the fund was devastated in the downturn of 2008, losing over 70% of its value in less than a year and half. By the March 2009 bottom, his fund’s cumulative return was back below the S&P 500’s, despite outperforming the index for more than a decade.
Bill Miller is a dramatic example, but the reality is most active fund managers do not outperform their respective benchmarks. Standard & Poor’s releases an annual study of active mutual fund managers. In fact, 85% of large-cap funds underperformed the S&P over 10 years, as did 85.7% of small-cap funds and 88% of mid-cap funds. Ouch!
So if this is a challenge for professionals, why would the average investor be any better? Well, they’re not. Research firm Dalbar conducts a study called QAIB, or Quantitative Analysis of Investor Behavior. The results are clear: Individuals are terrible at timing the market and consistently buy and sell at the wrong times. Over 20 years, this caused them to underperform the S&P 500 by about 4% annually. That’s a substantial hurdle to overcome.
The Case for Investing Today
The evidence is compelling — market timing simply doesn’t work for the average investor, as well as most professionals. Yet this is exactly what investors are doing when they wait for the right time to buy in.
Instead of trying to time the market, investors who have enough in their emergency savings should prioritize continuing to invest today. Getting into the market sooner rather than later is generally a mentality that will reap rewards over the long-term horizon. Here’s a case study that illustrates an important concept: It’s about time in the market, not timing the market.
During periods of volatility, some might make the case for dollar cost averaging. This is the process of investing chunks of cash over time to capture periods of depressed market prices (i.e. buying low). There is definitely some logic here, particularly if it refers to investing monthly savings. But the story is different if it refers to an existing pile of cash.
In 2012, Vanguard published a study on dollar cost averaging versus lump sum investing. It found that over 10 year rolling periods, investing cash in a lump sum was 67% more likely to outperform relative to dollar cost averaging. It assumed a mix of 60% stocks and 40% bonds. That’s a significant figure, and it makes sense given the positive expected returns for stocks and bonds. In other words, over longer periods of time, investing sooner rather than later captures more of the upside.
Before You Take Action
So what do I say when investors ask me if it’s a good time to buy? It’s almost always a resounding “YES” — regardless of where the stock market sits. This is true even with my personal investments. I never sit on cash unless I plan to use it in near future (or it’s set aside as an emergency reserve).
But before investing anything, it is critical you’ve established an appropriate asset allocation. This will help determine how much of your total investment actually goes into stocks. It is the percentage mix of domestic and international stocks, domestic and international bonds, alternatives, and cash. It is the single most important driver of long-term returns, and it will vary depending on your specific financial situation, goals and risk tolerance. Use Personal Capital’s free Investment Checkup tool to help assess risk and establish a target allocation.
Being fully invested in a diversified portfolio can increase expected return while simultaneously keeping risk at a comfortable level. Just make sure to stay on top of your asset allocation to match your risk tolerance over your lifetime.