If you are a new investor, you may have understandably been spooked by the ups and downs in the stock market earlier this year. Maybe you contemplated taking your money out of stocks and putting it in bonds, or even in a savings account for the time being.
However, timing the market is not a smart strategy for the average investor. Read on to find out why and also learn about three alternative approaches to investing which will hopefully prevent you from pulling your money out of the market in a panic - which is never a good idea.
Why You Shouldn't Try To Time The Market
The stock market is volatile. However, looking back, the stock market's gains have always outperformed its losses. This is why wealth advisors often advise a buy-and-hold strategy: to allow your investments in the stock market to recoup losses over time. Click here for a 100 Year Historical Chart Of The Dow Jones.
Because the stock market is so volatile, predicting how it will behave on any given day is very difficult, if not impossible. In fact, research shows that investors who try to time the market (i.e. buying and selling their holdings based on technical indicators or economic data) tend to underperform buy-and-hold investors.
There are two reasons for this. Firstly, an investor's transaction costs are higher when they trade more often, which erodes their returns. This is why, at Heron Wealth, we don’t recommend buying individual stocks to investors who are investing less than $500K. Instead, we believe that mutual funds with no load nor a transaction fee, and ETF's without a transaction fee are appropriate for smaller investments.
Secondly, some of the biggest upswings in value actually occur during volatile periods when many investors flee the market. In other words, there is an opportunity cost associated with selling in a panic when the market bottoms out. When the market goes back up, it will be more expensive to buy your way back in than if you had stayed in the market in the first place - so you lose out.
It seems counterintuitive but bear markets actually give investors the opportunity to buy good companies, or sometimes even the entire market, at a deep discount.
Professional traders sometimes argue that it's possible for them to successfully time the market and this may well be true. They are probably better informed than the average investor and also more capable of leaving emotion out of their investment decisions.
However, the reality is that even for professional traders it's very difficult to accurately time the market consistently over a long period of time. So what strategies are available to you instead?
1 A Buy-And-Hold Strategy Takes The Emotion Out Of Investing
The media have a tendency to exaggerate turmoil. It's sometimes hard to ignore the doom and gloom but that's exactly what you need to do. In addition to its volatile nature, there is a lot of noise in the financial markets. For example, the S&P 500 may be down by 1.5% today but it can easily go back up 2% tomorrow. You just don't know.
The best way for average investors to deal with market volatility is to take a buy-and-hold approach. This means that you're invested in the market for the long haul, ignoring the frequent ups and downs of the market, as opposed to trying to time the market. This long-term strategy is effective because it makes it easier to stop worrying about things you can't control: daily fluctuations due to changing interest rates, oil prices, politics - and focus on what you can control: saving and investing enough to achieve your long-term financial objectives.
How do you start? You begin by establishing a financial plan based on your age, income, lifestyle requirements and your projected retirement goals. It may make sense for you to talk to a financial planner or wealth advisor to help you set up a solid financial plan for you and your family which will subsequently inform your investment strategy.
2 The Advantage Of Dollar-Cost Averaging
For the average investor, making a set investment every month is a good idea. This technique is referred to as dollar-cost averaging and it is used in 401K plans. The same dollar amount buys you more stocks when the market is low and less stocks when the market is high. The idea is to take away the incentive to try and time the market as a result of daily fluctuations reported in the media.
Dollar-cost averaging is a good way to start investing because the deductions from your paycheck are automatic and, therefore, remove any emotion from the decision. Additionally, dollar-cost averaging can be a good start for hesitant investors to get a foot into the market by starting with smaller amounts of money.
3 Rebalancing Your Portfolio Periodically
Most investment portfolios are made up of a combination of stocks (equities) and bonds (fixed income). For example, at Heron Wealth we invest our clients in separate stock and bond portfolios, mutual fund portfolios and ETF portfolios. Instead of trying to time the market every time it goes up or down it's more helpful for you to rebalance your portfolio every five to 10 years (or have your wealth manager do this for you).
Stock prices tend to be more volatile than bond prices. You can gain more in the stock market, but you can also lose more. When you're in your twenties and thirties a 100% allocation to equities is fine because your portfolio has the time to recover from any major losses. In fact, the only time that an investor younger than 40 should have investments in fixed income is for short term cash needs, for example the down payment on a home.
Conversely, by the time you retire, it's prudent to have a combination of 70% in equities and 30% in fixed income (or slightly different variations in these numbers based on your specific financial situation).
Why allocate a percentage to fixed income? Because the risk exists that by the time you want to retire, the stock market could drop which may not give your portfolio enough time to recoup the losses. This could have disastrous consequences because you'll need the money for your living expenses in retirement.
Summing It Up
In summary, trying to time the market or pulling out your money when the market goes down is never a good idea. Instead, you'll get better results if you take a buy-and-hold approach, use dollar-cost averaging, and regularly rebalance your portfolio.