Beginners guide to investing part 10:Timing the market

Welcome back. So far in the series we have decided to invest in the stock market, our asset allocation, and who will manage the portfolio. Now we will think about when to invest. Spoiler alert, the best time is now. If you are new here, I recommend starting from the beginning.

 

INTRODUCTION

Ok, so we have decided on who is going to invest our money, now to decide whenhow much, and for how long to invest

Markets go up, down and sideways. Why, for how long, and when, is the big mystery. No one knows. It’s easy to say after the fact, but knowing the trigger for market changes beforehand is anyone’s guess. Strategies of trying to time the market are often wrong. For every buyer that gets the timing right, there is a seller that gets the timing wrong, and vice versa. This makes for a 50% success rate.

 

TIME IN THE MARKET IS MOST IMPORTANT

When we are first starting on our investing journey, the returns don’t matter so much. The important thing is just being in the market. Let’s say we invest $2,000 in the first year and the market has a terrible year returning minus 15%. We will lose $300 plus fees. Yes, it is a loss but in the scheme of our entire life, $300 is not a catastrophe. Likewise, if the market has a positive return of 15% we would be $300 better off. Not life changing despite the big returns percentage wise. Most of our investment funds in the first several years will come from our own investments, not the returns.

It is not until much later that returns matter much more. Say we now have $400,000 and we lose 15%.  That is $60,000. Now we are looking at more of a problem. This is because as we grow our investment portfolio, returns from our investments start to contribute more to our portfolio than the amount we put in. This is why trying to time the market early on is a waste of time, because all we are doing is delaying our progress. It is not until later on that we should start thinking about timing our selling. One common strategy is reducing our share investments as we age and moving to more safe investments, such as bonds. Imagine losing $60,000 the year before you are about to retire. 

The most important thing is just getting in the game and investing. See the table below for a visual description of how this works:

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I have assumed an average 7% return for simplicity sake, investing $2000 a year for 30 years. In the final two columns is where we can see the percentage of our own money contributed vs the percentage of investment returns we received. Both of these make up our total investment balance. As you can see, in the beginning years our own money makes up 93% of our returns. It is not until the 11th year of investing that the returns from the market overtake our own contributions. This is where it becomes much more important to minimise our losses, as they now make up a majority of our returns.

The trend in New Zealand is to spend most of our money on housing. Our own house is not an investment. The returns on housing are very low, yet that is where we continue to put most of our spare cash. It is not until we have heavily reduced or eliminated the mortgage that we then throw everything into investments such as shares and bonds. For many, that is too late to build up a decent size portfolio, as is seen in the table above. The best time to invest is now. Even if we have a mortgage. This will allow more diverse, and less risky asset holdings.

 

HOW MUCH TO INVEST - LUMP SUM VS DOLLAR COST AVERAGING (DCA)

The fact that you may be asking this question means that you have some money saved up. If you don’t have money saved, your only option for investing is dollar cost averaging. Investing a small amount regularly, i.e. every month.

You may have sold a house, a car, received an inheritance, got a promotion, bonus or even just been saving for a while and want to invest but haven't got your feet wet yet. With that money, we must decide whether to invest it all at once, or over time. More often than not, it is best to invest as soon as you can. Time in the market is more important than timing the market. This would mean that investing in one lump sum would make sense. Two thirds of the time, returns from lump sum investing beat dollar cost averaging. 

It is only natural though for many to be worried about investing in a one fell swoop. We are often worried that the market may be overpriced and prices may come down shortly.  But they may not.  Who knows?

Lump sum investing works best for those that are comfortable with more risk and someone who is not as good with budgeting. This is because a poor budgeter using dollar cost averaging, will be too tempted to use the monthly money earmarked for investments towards a flash new work suit or a fancy dinner. If you prefer the lump sum method, it only works if you invest as soon as you can. Waiting for a dip in the market until shares are cheaper is too risky and may involve too much time not invested at all. Some market commentators said the market had reached its peak in 2014. If a lump sum investor had the same thoughts, they would still be waiting now in 2018. The prices have only gone up since then. 4 years is a long time to be out of the market.

Dollar cost averaging works best for those that are worried that it is not the best time to invest, but would still rather be invested than sitting on the sidelines. Or for someone that doesn’t have a lump sum, or has already invested a lump sum and is now willing to continue investing with monthly contributions.

Basically, if markets are going up, lump sum wins. If markets are going down, dollar cost averaging wins. That is why two thirds of the time lump sum investing is better, because the market goes up two thirds of the time. Both strategies well and truly beat doing nothing and waiting for the right time.

Most of us don’t have the luxury of lump sums and dollar cost averaging works fine. Over time we buy shares when they are too expensive, but we also buy shares when they are a bargain. It averages out over time to reflect fair value. We just need to be patient and long-term focused for this approach.

Deciding between lump sum and dollar cost averaging comes down to the risk-reward trade-off common with all investment decisions. Even if a lump sum investment may produce a higher return, are you comfortable with the uncertainty and level of risk involved? How would you feel if the market dropped 10% immediately after your lump sum investment? Are you one to dive in the cold water head first or gradually enter the water from feet to head? If you are not comfortable, you need a new strategy.

 

HOW LONG TO INVEST - BUY AND HOLD VS BUY AND SELL

Buy and hold involves keeping our investments over an extended period of time, anticipating that the market will go up over that time. Buy and hold investing has lower costs because we are not paying someone to make trades all the time. It also requires less time and skill. We don’t need to research the market or know what is going on with the economy. We just have confidence in our strategy and stick to it. I am a buy and hold investor and don’t believe in trying to time the market. It is hard sometimes not to get emotionally involved. I almost felt like selling my shares after the Brexit votes came in, and again when the new coalition government came into power. If I did though I would be missing out on the market gains that have occurred since. It can be hard to ignore the news and doom and gloom merchants, and I deliberately don’t pay attention. It is common for someone to say to me “the sharemarket is going well isn’t it?”  It’s a bit embarrassing to admit but I don’t actually know how the sharemarket is doing at any given time. I don’t pay attention to it because my buy and hold strategy does not care for day to day price movements. My only concern is making enough money over 20 plus years.  

Because I am invested in both index and mutual funds, I either have a manager looking after my money, or I'm passively invested in the whole market. This means I don’t necessarily need to pay attention too much to the markets. Buy and hold works for me.

If you are self-managing your own investments however, buy and hold won’t work. Because you will be invested in fewer companies and don’t have a manager keeping an eye on the market for you, you will need to manage this yourself. Just because you may start off with a buy and hold strategy, it doesn’t mean you can set and forget. You will need to be prepared to change strategy and potentially sell non-performing assets. The reason a self-managing investor can’t rest on their investments is when you invest in fewer companies, the poor performance of one company has a much greater impact on your returns. One divided by 20 is a much higher number than one divided by 100.

A buy and sell investor is more proactive in the market and trying to manage their risk by selling when stocks are highly valued and buying when they are cheaply valued. The difficulty is knowing exactly when stocks are expensive and when they are cheap. We may sell when we think they are expensive, only to end up missing out on an extended run of gains. We may also buy thinking that stocks are cheap, only for them to continue falling further. We may sell as the market start to make a correction downwards, thinking a recession is on the way only to find out it was just a small blip, then we may have to buy the same stocks we just sold for more than we sold them for.

Just as my scenarios above pointed out the worst-case scenarios, the opposite could also happen where we time things perfectly and our predictions are correct. There is absolute potential for a buy and sell investor to do well by maximising gains and minimising losses. Buy and sell strategy works to minimise our risk because a buy and sell investor can minimise their losses better than a buy and hold investor by selling shares before they go too far down. Did they sell too low though? But will they buy back in at the right time? The losses from a buy and sell investor should be less than the buy and hold investor because they spend more time on the sidelines, but the question becomes can the gains of a buy and hold investor beat the gains of a buy and hold investor? Most evidence points to no, due to the emotions involved from a buy and sell investor, and lack of skill, expertise and time to be effective. There will always be outliers that prove this wrong, but it is part luck, and definitely the minority. I don't like those odds.  

Buy and sell investors take on less risk because they sell when things look bad and get out of the market. If they guess wrong though, the time out of the market can be very costly. An American example that also is relevant for New Zealand shows that between 1994 and 2013 (20 years), an investor would have made an annualised 9.2% return. If the same investor thought the market was high and decided to sell and missed out on the 20 best days of this period, they would have only had an annualised 3% return. That is worse than the average bank interest rate over that same period, yet for much higher risk.  Just 1 day per year (on average) out of the market would have cost a buy and sell investor with $100,000, over $120,000. To be fair though, a buy and sell investor may not have been in the stockmarket for the 20 worst days, whereas a buy and hold investor would have. The point is a large majority of stock market gains are made from just a few days per year. The conundrum is we don’t want to miss those days, but we do want to miss the few worst days that have the biggest impact on losses. Good luck picking 20 days out of 5,000.

We need to decide how long we want to invest for. For shorter periods (7-10 years), buy and sell MAY work in our favour. This is because there is a greater chance of losing money in a 10-year period than there is in a 20-year period and buy and sell tends to work better in falling markets. According to our risk profile, if we fear losses then buy and sell may be the way to go but how do we know our timing to exit the market is right?  If we fear losses that much though, I would question why we are in the market at all. Buy and sell is absolutely necessary if we are an active stock picker, since we are not as diversified as a passive index investor. We must decide on the amount we can afford to lose and get out when our stock reaches that value.

 

FINAL THOUGHTS

Minimising losses is, in a way, making gains. If we are losing less than the market, then that can be considered a gain against the alternative. But I think there are better ways than buy and sell to minimise our investing risk. Especially when starting out, as time in the market is much more important to our growth than timing. By holding a diversified portfolio in a wide range of asset classes, both nationally and internationally, that should be enough to minimise our risk. Each on their own is risky, but when grouped together in a uncorrelated way in our portfolio, our risk is greatly reduced. One investment goes down, another goes up.

If we want another added layer of protection, then dollar cost averaging may also be a good strategy to employ to smooth out our returns to more closely match the market average. If we have all the above I think that is enough to maximise returns, whilst also minimising risk. Buy and sell investing on top of this should not be required, only when we need to rebalance our portfolio. Yes, we may be stuck in the worst days of the stock market with a buy and hold philosophy, but how do we even know at the time they are the worst days. They may turn out to be the new normal. The point is, market timing is not for the average investor with limited time and standard goals to achieve. Maybe for people with nothing to lose and lofty ambitions, or someone who is only risking a small percentage of their portfolio. There will be success stories, but with every success story there will be several stories of failure. We don’t tend to hear those ones though.

We want a portfolio strong enough to withstand all elements without having to tinker around all the time. Buy and hold, passive investing may be boring, but it is cheap, and it gets the job done just as well, if not better than more expensive and time consuming active investing. Just because something is easy and boring doesn’t make it bad. In fact, in my opinion, it makes it better. This is an instance where more effort can actually hurt.

Next up we will discuss the ways that shares can make (and lose) us money.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

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