Investors are always looking for ways to improve returns, including adding steps to determine when to add new investments to a portfolio. This post explores timing strategy, and why the practice of managing the contribution schedule will make improving returns unlikely.
One of the basic principles of sound investing is ‘do not try to time the stock market.’ With that in mind, let’s consider whether new or starting contributions to an investment portfolio can be “timed” in order to obtain lower average prices, and better returns. You might have already heard this as “waiting for the dip.”
The Stock Market is a Risky Place
The inspiration for this piece comes by way of this chart from Mr. Barry Ritholtz of Ritholtz Wealth Management, not to mention several related discussions over at the Bogleheads forum. The chart shows the extent of ‘intra-year’ downside volatility in the stock market, even in “up” years. I am not sure what his point was, since the chart did not include any commentary, but I don’t think he advocates market timing. In any case, market volatility is no surprise. After all, the stock market is a risky place. (One issue I have with the chart is that it does not display the interim low percentage from the S&P 500’s yearly starting value; instead, the interim low is measured from its peak to trough. Since we do not know, in advance, what the peak will be for a given year, that makes this information pretty pointless. I included this chart only to show why investors might be motivated to do timing of purchases.)
By the way, it does not matter whether timing is to “jump in and out of the market,” or it is just to add new shares to an existing portfolio. Both processes encompass the same idea, which is the timing of new investments of cash into equities or other long-term investments. Jumping in and out is worse because you have to be right twice!
Conceptually, it is easy to incorrectly conclude “waiting for the dip” will provide you with lower average prices. After all, the nature of markets is that they are unpredictable and volatile, so a dip should happen often. Why not just wait until then before buying?
Emotionally, we want to believe we can predict what markets will do next. Humans hate uncertainty, so it is a normal tendency to look for patterns, strategies, or anything that might reduce our discomfort with that uncertainty, including “waiting for the dip.”
If there is a ‘really bad day,’ the market must bounce back. If the market has rallied for five days, there must be a pullback soon. These are typical thoughts that drive behavioral errors. Selectively timing stock purchases is a behavioral error. To understand why, ask critical questions, like:
- Do I know or feel this will happen?
- If I know, how do I know that?
- If I know, why is the knowledge so unique that only I know it?
- If I alone really know, why don’t I go ahead and mortgage the home, borrow to the hilt, then buy out-of-the money options to capitalize?
If you somehow explained your ability to time the market all the way through to the last question, what are the facts supporting what you will do and why it works? How do you know it will continue to work in the future? It is impossible with the stock market, but if you have discovered the alchemy, congratulations. But…I suspect you have not.
Intellectually, we think stock market returns follow a normal distribution. The thought here is that, for every day the market goes up, the greater the chance it will fall tomorrow. Eventually, there is a reversion to the mean. The problem with it is that in the short run, the period during which we are making new investments, market price movements are entirely random. If you repeatedly flip a coin and happen to get heads 10 times in a row, the following flip still has the exact same odds of landing on heads as the last ten.
In the short run, the market is a voting machine but in the long run, it is a weighing machine. ― Benjamin Graham
Let’s say you devised a strategy such as, only invest after the market drops by 5%. You can certainly count on that drop happening…eventually. Nevertheless, how do you know buying right now is not the lowest price? That is, today’s price may be lower than the one after the future 5% drop, because prices could go up 10% first, before finally falling 5%. When you decide to ‘wait for the dip,’ you have concluded that prices are going to fall 5% below today’s price. How can you possibly predict that?
We’re Here to Help
Enter the financial services industry, and particularly, their human or robo advisors.
All active strategies are built around a subtle (and for some, a not so subtle) notion that its purveyor has a unique strategy (market timing, unique security selection, trading strategy) and that it can be used to exceed the market’s return. You want to believe it because it would mean that someone who knows what they are doing will make everything right so you do not have to worry about the uncertainty. I can be cynical-minded, so please take this with a few grains of salt. The financial services industry thrives on its ability to take advantage of your behavioral flaws. Specifically, they leverage your fear of market uncertainty. They sell you with comforting talk about how well their professionals know financial markets, and that the markets are far too complex for you to go it alone. The reality is they know as little about what the market will do tomorrow than you or I.
Real help is pretty basic and simple (and does not require armies of salaried, commission-based, or automated advisors). For example, this article helps investors evaluate, on their own, their individual need, ability, and willingness to take risk, and in an honest way. You can determine on your own the amount of market risk appropriate for you, and the largest determinant of risk is simply selecting the ratio between stocks and bonds. When you take the right amount of risk in the first place, you won’t want or need hand-holding.
If Passive is Right, What Next?
I hope this motivates you to consider making all your own investment decisions if you do not already. Understand how the financial services industry really operates then use it to override your normal tendency to make behavioral errors. Once you do, you can invest independently and with confidence. Passive investing works. Because we do not know what markets will do, we only seek the market’s return, minus the low expenses of the index funds.
After you set an asset allocation that fits your goals, and fits your need, willingness and ability to take on risk, you will need to make systematic investments over time to grow your portfolio, but you will not need Robos, human advisors, and their strategies to do it.
If you set up automatic investments with your broker and your bank for scheduling recurring deposits on the same day each month, it is good enough. Some months, the new investment will be made at the low price for the month, and other months they will not, but over time you will build wealth and you will get the average prices of the market. Next week, I will delve into automatic investing in more detail.
The bottom line is that the best time for an additional investment is always now, and that time in the market is more important than timing the market.
If you want to be more active with your new cash, look at your current portfolio allocation percentages for each asset class relative to their target percentages, and if your allocation has gotten out of balance, send new contributions to those funds that will bring it back into balance. You will be buying the asset class that has gotten cheaper relative to the others. This is not about timing or trying to guess which asset is better to buy right now. It simply means you are adjusting where your new investments are made so the allocation will match the percentages you already set.
Simple is better. If you are scheduling $300 a month, and you have a 60/40 portfolio, you can send 60% to the stock market index(es), and 40% to the bond market index every month, and then deal with adjustment at time of rebalancing.