Mark Riepe, Senior Vice President, Schwab Center for Financial Research shares the following with Dumb Little Man readers:
Imagine for a moment that you’ve just received a year-end bonus or income tax refund. You’re not sure whether to invest now or wait. After all, the market recently hit an all-time high. Now imagine that you face this kind of decision every year — sometimes in up markets, other times in downdrafts. What’s a good rule of thumb to follow?
Our research definitively shows that the cost of waiting for the perfect moment to invest far exceeds the benefit of even perfect timing. And because timing the market perfectly is, well, about as likely as winning the lottery, the best strategy for most of us mere mortal investors is not to try to market-time at all. Instead, make a plan and invest as soon as possible.
FIVE INVESTING STYLES
But don’t take my word for it. Consider our research on the performance of five long-term investors following very different investment strategies. Each received $2,000 at the beginning of every year for the 20 years ending in 2006 and left the money in the market once invested.(1) Check out how they fared:
- PETER PERFECT was a perfect market timer. He had incredible skill (or luck) and was able to place his $2,000 into the market every year at the lowest monthly close.
For example, Peter had $2,000 to invest at the start of 1987. Rather than putting it immediately into the market, he waited and invested after month-end November 1987 — that year’s monthly low point for the S&P 500® Index (a proxy for the stock market).
At the beginning of 1988, Peter received another $2,000. He waited and invested the money after January 1988, the monthly low point for the market for that year. He continued to time his investments perfectly every year through 2006.
- ASHLEY ACTION took a simple, consistent approach: Each year, once she received her cash, she invested her $2,000 in the market at the earliest possible moment.
- MATTHEW MONTHLY divided his annual $2,000 allotment into 12 equal portions,which he invested at the beginning of each month. This strategy is known as dollar cost averaging. You may already be doing this through regular investments in your 401(k) plan or an Automatic Investment Plan (AIP), which allows you to deposit money into mutual funds on a set timetable.
- ROSIE ROTTEN had incredibly poor timing — or perhaps terribly bad luck: She invested her $2,000 each year at the market’s peak, in stark defiance of the investing maxim to “buy low.” For example, Rosie invested her first $2,000 at the end of August 1987 — that year’s monthly high point for the S&P 500. She received her second $2,000 at the beginning of 1988 and invested it at the end of December 1988, the peak for that year.
- LARRY LINGER left his money in cash (using Treasury bills as a proxy) every year and never got around to investing in stocks at all. He was always convinced that lower stock prices — and, therefore, better opportunities to invest his money — were just around the corner.
We looked at how much wealth each of the five investors had accumulated at the end of the 20 years (1987–2006). Actually, we looked at 62 separate 20-year periods in all, finding similar results across almost all time periods.
Naturally, the best results belonged to Peter, who waited and timed his annual investment perfectly: He accumulated $146,761. But the study’s most stunning findings concern Ashley, who came in second with $141,856 — only $4,905 less than Peter Perfect. This relatively small difference is especially surprising considering that Ashley had simply put her money to work as soon as she received it each year — without any pretense of market timing.
Matthew’s dollar-cost-averaging approach delivered solid returns, earning him third place with $134,625 at the end of 20 years. That didn’t surprise us. After all, in a typical 12-month period, the market has risen 75 percent of the time.(2) So Ashley’s pattern of investing first thing did, over time, yield lower buying prices than Matthew’s monthly discipline and, thus, higher ending wealth.
Rosie Rotten’s results also proved surprisingly encouraging. While her poor timing left her about $18,262 short of Ashley (who didn’t try timing investments), Rosie still earned significantly more than double what she would have if she hadn’t invested in the market at all.
And what of Larry Linger, the procrastinator who kept waiting for a better opportunity to buy stocks — and then didn’t buy at all? He fared worst of all, with only $61,622. His biggest worry had been investing at a market high. Ironically, had he done that each year, he would have still earned more than twice as much over the 20-year period.
THE RULES DON’T CHANGE OVER TIME
Regardless of the time period considered, the rankings turn out to be remarkably similar. We analyzed all 62 rolling 20-year periods dating back to 1926 (e.g., 1926–1945, 1927–1946, etc.). In 52 of the 62 periods, the rankings were exactly the same; that is, Peter Perfect was first, Ashley Action second, Matthew Monthly third, Rosie Rotten fourth and Larry Linger last.
But what about the 10 periods when the results were not as expected, as illustrated in the table? Even in these periods, investing immediately never came in last. It was in its normal second place four times, third place five times and fourth place only once, from 1962 to 1981, one of the few periods of persistently weak equity markets.What’s more, during that period, fourth, third and second places were virtually tied.
We also looked at all possible 30-, 40- and 50-year time periods, starting in 1926. If you don’t count the few instances when investing immediately swapped places with dollar cost averaging, all of these time periods followed the same pattern. In every 30-, 40- and 50-year period, perfect timing was first, followed by investing immediately or dollar cost averaging, bad timing and, finally, never buying stocks.
WHAT THIS MEANS FOR INVESTORS: DON’T WAIT
If you make an annual investment (such as a contribution to an IRA or to a child’s 529 plan), and you’re not sure whether to invest in January of each year, wait for a “better” time, or dribble your investment out evenly over the year, be decisive. The best course of action for most of us is to create an appropriate plan and take action on that plan as soon as possible. It’s nearly impossible to accurately identify market bottoms on a regular basis. So, realistically, the best action that a long-term investor can take, based on our study, is to invest at the first possible moment, regardless of the current level of the stock market.
If you’re tempted to try to wait for the best time to invest in the stock market, our study suggests that the benefits of doing this aren’t all that impressive — even for perfect timers. Remember, over 20 years, Peter Perfect amassed less than $5,000 more than the investor who put her cash to work right away.
Even badly timed stock market investments were much better than no stock market investments at all. Our study suggests that investors who procrastinate are likely to miss out on the stock market’s potential growth. By perpetually waiting for the “right time,” Larry sacrificed $61,972 compared to even the worst market timer, who invested in the market at each year’s high.
CONSIDER DOLLAR COST AVERAGING AS A COMPROMISE
If you don’t have the opportunity, or stomach, to invest your lump sum all at once, consider investing smaller amounts more frequently. Dollar cost averaging has several benefits:
- PREVENTS PROCRASTINATION. Some of us just have a hard time getting started. We know we should be investing, but we never quite get around to it. Much like a regular 401(k) payroll deduction, dollar cost averaging helps force yourself to invest consistently.
- MINIMIZES REGRET. Even the most even-tempered stock trader feels at least a tinge of regret when an investment proves to be poorly timed. Worse, such regret may cause you to disrupt your investment strategy in an attempt to make up for your setback. Dollar cost averaging can minimize this regret because you make multiple investments, none of them particularly large.
- AVOIDS MARKET TIMING. Dollar cost averaging ensures that you will participate in the stock market regardless of current conditions. While this will not guarantee a profit or protect against a loss in a declining market, it will eliminate the temptation to try market-timing strategies that rarely succeed.