How to Invest Step 3: When should I buy?
This Blogpost is part 3 of a bigger series called “How to Invest”.
Part 1 answered the question of how much you should invest while part 2 focused on what to buy. The big remaining question is is “When should I buy?”.
Your Options
Let's first look at your options. Whenever you invest in something, you have the following 3 options:
Timing the Market: Wait for the perfect moment. Try to pick the bottom, wait for the crash and stay in cash until this moment has come.
Lump-Sum Investing: Invest right now - buy as soon as possible and stay invested.
Dollar-Cost Averaging: Move your funds into the asset iteratively bit by bit, over a certain period of time.
So lets look at those 3 options in more detail.
Timing the Market
Timing the market basically means "picking the bottom" and "selling the highs". It describes the intention of waiting for the market to fall (in terms of your local currency), and then, when everyone else has given up, when there's blood in the streets, when the future looks most dismal, when the price can't possibly go any lower, then you invest all your cash, earning massive returns over the following weeks as the asset comes back from the dead. And then years later, when the market is in a bubble, you'll take your profits and sell out and go back into cash.
So what do the experts say about timing the market? The concept sounds cool but unsurprisingly, it doesn't work.
As this video explains, it is one of the most dangerous things that you can do. First of all, the experts agree that nobody can do it consistenly - whether professionaly or not. In fact, by trying to time the market, you are much more likely to miss out on early gains in the market. Later your emotions will get a hold of you. Unwilling to miss out on any further gains, you'll probably end up buying when things look great and sell when things look terrible. For example, more money went into equity mutual funds in the first quarter of 2000, which was at the height of the Dot-com bubble, than ever before. This turned out to be exactly the wrong time to put money into the market. And then a lot of funds went out of the market in the third quarter of 2008 at the height of the financial crysis, when everyone was saying the world was falling apart, which turned out to be exactly the wrong moment to sell.
"I don’t believe in market timing. I’ve been around this business darn near a half-century, and I know I can’t do it successfully. In fact, I don’t even know anyone who knows anyone who has ever successfully timed the market over the long term." - John Bogle
"There is an overwhelming body of evidence to support the view that believing in the ability of market timers is the equivalent of believing astrologers can predict the future." - Larry Swedroe
Finally, as this article explains, by trying to time the market and increasing the frequency of your trades, you'll end up inducing high cost due to transactions and paying higher taxes. Also, it's important to note that "doom & gloom" headlines are normal. You'll always hear voices proclaiming the end of the bull market the glooming recession. If you listen to those voices, you'll end up selling early and missing out on any future gains.
Lump-Sum Investing vs. Dollar-cost Averaging
Hopefully at this point we have established that waiting for the bottom is a bad idea. You'll have to acknowledge that you cannot time the market and if you try it you'll end up losing money. Also, in Part 1 we already established that cash is a terrible investment, so you better move into other assets. These assets were discussed in Part 2.
That leaves us with the following two options: You either buy right now and stay invested - or you invest your money interatively over a period of time.
Dollar-Cost Averaging
The main benefit of dollar-cost Averaging is reducing risk by avoiding to invest all your funds at a potentially unfavourable moment. In this strategy, you invest portions of your money at certain predefined intervals over a period of time. The main drawdown of this strategy is that, since stock market is biased to rise over time, you'll be likely to miss out on early capital gains and compounding effects. Usually, investors choose to invest their money monthly or quarterly over the period of 1 to 3 years. On longer-term time horizons (more than 3 years) the inflationary forces on cash become more apparent and you're bound to lose wealth.
Dollar-cost averaging works really well for more risk-averse investors that have larger sums of money and that want to avoid investing right before a market drawdown.
The main problem with dollar-cost averaging is discipline. If you don't automate all future transactions and commit to a plan, you run the risk of staying in cash or getting influenced by your emotions, still attempting to pick highs and lows in the market. After all, imagine the market crashed: it takes a lot of conviction to stick to your plan an pour money in a crumbling stock market.
Lump-Sum Investing
In lump-sum Investing you take all the money that you want to invest and put it right into the stock market. Also, every time you get additional funds that you could invest (e.g. a yearly bonus), you invest it right away. The key difference to dollar-cost averaging is that you are not intentionally holding onto the funds for a later time to invest.
The main advantage of lump-sum investing is that you'll profit immediately from capital gains and the magic of compound interest. The main risk of course lies in picking precisely the wrong moment and investing at the peak.
What the studies show
So which one is better - dollar-cost averaging or lump-sum investing? Suprisingly the reseach is clear. A study by Vanguard found that over a 10-year period, lump-sum investing beat dollar-cost averaging about two thirds of the time. In their own words:
We conclude that [..] the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible. But if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use. - Vanguard Research, 2012
Limitations
The underlying assumption for the above to be valid is that you invest according to the previous blog post in a low-cost, equity-based, well-diversified index fund - and that you stay invested for the long-term. That means, you stay invested - especially during those dark times when all the headlines are dismal and the furture looks grim. However, the above is not valid for short-term speculation and active investing. In active investing you’ll attempt to outperform the market by going long/short certain assets, by using leverage and/or by attempting to time the market. As soon as you deviate from investing in a low-cost, equity-based, well-diversified index fund, the two options recommended by the experts above (lump-sum investing and dollar-cost averaging) are no longer valid. For example when investing in individual stocks additional consideration have to be taken into account - such as company valuation. Over the long run, these assets might behave very differently from the market portfolio and can go to zero. For this reason, one cannot simply keep pouring money into these assets without considering their intrinsic value, market expectations, and possibly even the right moment to buy.
Favorite sources discovered while researching for this post:
Meb Faber and Andrew Horowitz on the right moment to buy (at position 01:01:30) https://pca.st/xy6ynr74#t=3690
On the topic of Market Timing:
On the topic of Lump-Sum Investing vs. Dollar-Cost Averaging:
Disclaimer:
I am no financial advisor and this is not financial advice. So don’t sue me when your portfolio blows up. Do your own due diligence.
Before making any investment decision, you should seek financial, legal, tax and accounting advice, taking into account your individual financial needs and circumstances and carefully considering the risks associated with such investment decisions.