Long-term investors typically don’t try to time the market. Find out why (hint: it’s risky and can be expensive).
Long-term investors typically don’t try to time the market because it’s risky and can be expensive. Attempting to time the market can mean missing opportunities. And buying and selling frequently in an attempt to capture market ups and downs increases transaction costs, which can lower returns.
The risk of attempting to time the stock market is illustrated in figure 1, which shows drastically reduced returns as a consequence of missing the one best month on annual returns. For years when returns were already negative, the effect of missing the best month only exaggerated the loss for the year.
FIGURE 1: THE RISK OF TRYING TO TIME THE MARKET.
This chart shows the effects of missing the best months of each year. Data source: Stocks are represented by the Ibbotson® Large Company Stock Index. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance does not guarantee future results.
In seven of the 45 years shown in figure 1, otherwise positive returns turned into negative returns by missing the best month (in 1970, 1978, 1984, 1987, 1994, 2011, and 2015). This is one reason why buy-and-hold investing can be an effective strategy. For long-term investors, it’s not about timing the market; it’s about time in the market.
So, how can you, and your portfolio, endure the ups and downs and manage to stay invested for the long haul?
Managing risk helps you stay invested during market downswings and helps you maintain that long-term perspective.
It’s a popular saying among boxers: “Everyone has a plan until they get hit.” Let’s face it, a bear market can hurt. That’s why investors manage risk—to soften the blows to a portfolio. It’s also why it’s important to understand that the stock market moves in cycles, with periods of contractions followed by periods of expansions.
There have been eight market downturns in the past 42 years. In figure 2, the regions shaded in orange highlight the contraction phase of a stock market cycle, and the green regions show the expansion phase. A contraction is defined by a period when the stock market declined from its peak by 10% or more. The last contraction happened during the financial crisis, beginning in November 2007 and ending in February 2009. The stock market recovered in March 2012.
FIGURE 2: STOCK MARKET CONTRACTIONS AND EXPANSIONS.
Data source: Large stocks are represented by the Ibbotson® Large Company Stock Index. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance does not guarantee future results.
Although some periods of decline have been severe, the overall market has grown over time. For instance, the stock market fell from its peak at the end of May 1990 to its low in October 1990 by 14.7%, but grew by 355.1% from November 1990 to its next peak in June 1998.
No one can predict market declines with certainty. But investors with a long-term perspective might be better prepared to allow a portfolio to fluctuate and grow.
One way to try to even out the fluctuations in the market over long periods of time is with dollar-cost averaging (DCA). DCA involves investing a certain amount of money into particular investments on a regular schedule regardless of price.
DCA works to smooth out the ups and downs because more shares of an investment are purchased when the price is low, and fewer shares are purchased when the price is high. Over time, the average price per share can even out.
Reinvesting dividends is another long term investing idea. This technique is referred to as a dividend reinvestment plan, or DRIP. You can set your account to reinvest eligible dividends automatically. Bonus: reinvesting dividends is another way of harnessing compound interest.
In the next article in this series, I’ll show you some tools and resources that can help with creating and managing a long-term investment portfolio.
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