Lesson 3-Timing the Market and Dollar-Cost Averaging
Updated: Oct 14, 2021
Active investors attempt to use predictive models developed via extensive fundamental and technical research/analysis to time the market, maximizing profits and minimizing losses by avoiding market volatility and selling stocks before a downturn. In contrast, buy-and-hold investors ride out market volatility instead of trying to time when to buy or sell a given stock. For most investors, trying to time the market is a zero-sum game as profits made shifting in and out of the market equal losses incurred, such that in the long run they underperform passive buy-and-hold strategies.
To demonstrate the complexity in market timing, investing in the S&P 500 from 1995-2014 would have generated an average annual return of 9.85%, however, by missing 10 of the best market days, the average annual return falls to 5.1%. Likewise, investing $1,000 in the S&P 500 from 1991-2020 would have returned $21,115, compared to $8,117 if an investor missed the top 10 performing months. The biggest market upswings can occur during volatile periods when active investors typically exit the market. Due to the fact that 10-year returns for the S&P 500 have been negative only 6% of the time since 1929, Bank of America advocates buy-and-hold strategies as the best strategies to avoid losses and benefit from market upswings.
Active investors timing the market underperformed the S&P 500 by as much as 3%, due to higher transaction costs, taxes on capital gains, and commissions from consistently entering and exiting the market. According to Nobel Laureates, investors using market timing must be correct 74% of the time to beat the benchmark index, this is unlikely as only 23% of all active funds beat their passive counterparts over the 10 year period ending 2019. In order to identify optimal entry and exit points, active investors must consider factors affecting a stock’s price including changing market trends, macro and political events, commodity prices, disposable income and consumer confidence, inflation and interest rate expectations, effects of R&D on profits and many more. Investors may be unaware of such factors and therefore may misjudge stock price movements. Additionally, emotive decisions may render research useless if investors overreact to bad news by selling stocks, or like in the dot-com bubble, buy into grossly overvalued stocks falsely advertised as quick profit stocks due to their enormous price swings. In summary, investors timing the market run the risk of missing periods of high return and end up underperforming the broad market, only identifying a market high or low after it has happened.
For example, the Covid-19 stock market crash was characterized as the shortest market crash in history, returning to pre-crisis levels within 6 months. Most financial experts, including John Rekenthaler of Morningstar, published articles forecasting that the crash would last 2 years, similar to the financial crisis of 2008. Demonstrating how even the most financially literate/proficient names in the industry can make erroneous forecasts. Most experienced investors, academics, and financial professionals recognize the difficulty in consistently timing the market and advocate buy-and-hold strategies. In summary, it is much more beneficial to maximize time in the market rather than timing the market, the longer the investment horizon the higher the capital gain.
The market timing strategy is suited for short-term active investors, including professional day traders, portfolio managers, and full-time investors, conducting extensive research to develop financial models which identify optimal entry and exit points. However, the probability of consistently timing buy and sell orders just before the stock price goes up or down decreases exponentially over the medium to long run. Few investors can predict shifts to a level of consistency where they gain significant advantages over buy-and-hold investors. For example, the average equity mutual fund investor earned a return of 26.14% in 2019, compared to 31.49% returned by the S&P 500. Based on net purchases or sales from each month of that year, the average active investor correctly timed the market 3 times in every 12 attempts, a success rate of just 25%. This demonstrates how the cost of waiting for optimal entry and exit points exceeds the benefits of market timing and that the best strategy for most investors is a buy-and-hold strategy.
A study was conducted for investors with $2,000 invested in the S&P 500 over 77 different 20 year periods. According to the study, the principal grew to $135,471 by investing at the beginning of the 20 year period, compared to $151,391 by timing the market perfectly. Given that it is impossible to perfectly time the market consistently, investing a lump sum at the beginning of the period would be the best strategy. However, this strategy does not protect investors from losses incurred in the unlikely possibility of a market crash after investing the lump sum.
Dollar-cost averaging (DCA) is a strategy where investors divide the amount they intend to invest by buying smaller quantities of the asset over a given time period at regular intervals. It is the practice of systematically investing equal amounts regardless of the stock price. In contrast to the long-term, near-term asset prices do not rise consistently, instead they experience short-term highs and lows. By using DCA, investors buy fewer shares when prices are high and more when prices are low, resulting in investors maximizing the chance of paying a lower average price over the time period. DCA avoids the mistakes from emotive decisions and poorly timed lump-sum investments.
Investing $10,000 per month over 10 months into the stock market is an example of using DCA to invest $100,000. Despite potential higher long-term returns by investing the principal at the beginning of the period, investing small amounts in regular intervals avoids market peaks by buying during the market lows and highs. If the commission charged on an investment exceeds 1% of the trading value, an investor should buy over larger intervals (i.e. once every other month instead of every month) or invest over a shorter period (i.e. over 6-months instead of a year) until 1% of the trading value in each period exceeds the commission charged.