The following guide first explains how the stock market works. Then, we’ll look at stocks vs mutual funds that hold stocks. We’ll finish by looking at the main ways people invest in the market and help you determine which method fits you best.
Stock Market Overview
Many people are intimidated by investing in the stock market because they don’t understand the basics. Well, if that describes you, we’re about to solve that problem once and for all.
To understand the stock market think about any other market and you’ll be a master. In markets, people who have stuff to sell “meet” with people who want to buy and they trade with each other. That’s it. And that’s exactly how the stock market works today. It’s also how it got started several hundred years ago.
In the late 1700’s business owners who wanted to expand their business put up notices in downtown Manhattan – on Wall Street and Broadway. Entrepreneurs who needed money to grow their business back then would pin up advertisements and offers on trees. If someone was interested in investing they would contact the business owners who were looking for investors and negotiate the deal.
Usually, this resulted in those investors owning a piece of the overall business. That was the formula then and it hasn’t changed very much since. When you own stocks you become a part owner of the company. When you buy a mutual fund that buys many stocks, you become a part owner of many companies.
Why do some people say that stocks are good investments for the long run?
This is THE key question when it comes to stocks. And to fully understand the answer, let’s look at the S&P 500 index. Why? Because this index is a compilation of 500 of the largest companies in the United States (and the world) and is considered a proxy for the entire market.
On any given day, some of these stocks go up and others go down in price. The combined result is the performance of the index and is one of the most widely followed numbers by investors. They use that performance over varied time frames to get a sense of how the market is doing. You’ll see why this is important shortly.
Who decides which companies are included in this index?
S&P stands for Standard and Poors – a private company. This is the firm that created the index and they decide which companies are included in the index and which are not. They select the companies based on a number of factors. These companies are drawn from either the NYSE or NASDAQ market exchanges. Usually changes are made the index each year. Some new companies are added to the index while others are taken out. This is very important because in effect, the S&P is constantly changing. You’ll see why I make this point shortly.
How Have The Stocks That Make Up The Index Performed?
Here’s a graph to give you an idea:
This indicates that over long periods of time, the S&P 500 has done a good job of helping investors accumulate wealth in the past. Of course, it’s no guarantee of future results.
Why has the value of these companies gone up over time? There are many reasons. But mainly, stock prices move over the long-term because of the company’s earnings. Over time, if a business earns greater profits, it is worth more because it has the potential to pay out dividends or invest further to earn still greater profits. If profits rise, the business will be worth more and if the business value grows so will its share price.
Let’s take an example. Let’s say you start a painting company and in year one, your profit was $25,000. If your neighbor offered to buy your company for $50,000 you might sell. But what if you don’t sell. And what if your profit skyrockets to $100,0oo the following year? Would you sell for $50,000 then? Of course not.
You’d want at least $200,000 and maybe quite a bit more. That’s because the future looks bright and you might prefer to hold on to the company and profit $100,000 this year (and hopefully more next year) rather than sell out at $200,000 and be out of the picture. So you see, as earnings rise, so does the value of the company. If that company is traded on the stock exchange, you’ll see the shares go up over time as earnings go up. This doesn’t happen immediately or in lock-step. But over time, stock values rise with company earnings.
Keep in mind that the opposite is also true. If earnings fall, the value of the company and its shares usually fall as well.
There is one very important caveat to emphasize; earnings drive stock prices over the long-run but not necessarily over the short-run as I mentioned before. Over a short period of time, the market is ruled by emotions – mostly fear and greed. Real earnings may have nothing to do with short term prices. Perceptions are everything for the short-run.
If, for various reasons, people are frightened and anxious about the future, share prices could fall. This can and does happen even to companies that are doing well and have strong and growing profits.
If the market (buyers and sellers) think that hard times are ahead and that it will be more difficult for companies to grow the profits, they will rush the exits to get out of their shares and many will be willing to sell at lower and lower prices.
And just to give you a sense of how unimportant short-term stock prices can be, consider extreme changes that happen on a daily basis. Can share prices rise or fall by 10% in one day? Of course. It happens all the time. But do you really think the value of the company changes that much in 24 hours? It can happen of course. But usually it doesn’t. When something really surprises investors such as the Brexit vote outcome in 2016, global markets immediately took a dive because people were caught off guard. That was an emotional reaction. But within a couple of weeks, world-wide markets stabilized because investors realized nothing had really changed at that point.
Over the short-term, what changes is perceptions and that’s what fuels daily price movements – not value. To be fair, perceptions can change in response to real events. That’s true. But it’s usually the emotional reaction to those events which move stocks – not the events themselves. And that’s why investing over the short-run is typically more risky than long-term investing. Over the short-term, it’s all about emotions. Over the long-run, it’s all about earnings.
Should you invest in the stock market?
Assuming you don’t have serious debt, you have an adequate emergency fund, you can save money each month, you can stomach the ups and downs of the market and you have at least a 5 to 10 year investment time horizon, there is probably a case for investing at least a part of your money in the stock market.
Why all the caveats?
The goal of investing in stocks is to grow your wealth over time. And we’ve already seen that in any one year (and often longer) the market can experience wild gyrations. If you need your money soon, the market isn’t for you.
Also, if you are have high cost credit card debt, don’t invest. Instead, get rid of that debt first because you get a high guaranteed “return” in the interest that you save.
If you don’t have any emergency money set aside and you run into a sudden, unexpected need for cash, you’ll have to sell your investments. If that happens at a bad time and the market is weak, you could be forced to sell at losses. That’s why you should first set up an appropriate emergency fund before investing.
And that’s not all. You must have the emotional fortitude to stick with your investment strategy through thick and thin to be a good investor as well. Many people aren’t able to do that. And what happens is that they react emotionally when the market takes a tumble and cash out at often the very worst times. We’ll talk about how to overcome this problem in just a bit.
JP Morgan did a study and found that for the 20 year period ending 2014, most investors underperformed the market significantly for this exact reason – they reacted emotional to the market and failed to let the ups and downs even out over time. Marketwatch did their own digging into this issue and made similar conclusions.
In the JP Morgan study, the average investor earned only 2.5% per year over this time period while a balanced fund made up of stocks and bonds grew by more than 8%. Why the difference? Because individuals often pull the plug at the exact wrong times as a result of fear.
This is not to say that if you hold on for 5 or more years you are guaranteed a great return. There are no promises. There have been many long stretches of time with little or no return in the market. In order to make money in the market, the longer you invest and the longer you stick with the right strategy, the better your chances are.
Stocks or Funds?
When people invest in the stock market they either do so by purchasing individual stocks or funds. There are other ways to invest. But by far, these are the two most prominent.
When you buy individual stocks you are making a (relatively) large bet on one company. When you buy a mutual fund your theoretical risks are dispersed. That’s because of the diversity mutual funds and ETFs offered as I explained above. A fund often owns hundreds or thousands of different stocks.
So, if you buy stock in one company, you might invest $100 and buy 10 shares of XYZ stock for $10 each.
But instead, if you buy 10 shares of AAA Mutual fund at $10 each you might own a little part of 500 different company’s stocks held in that fund. That means you have a lot less risk (relatively speaking) with funds as opposed to stocks.
Cost of Stocks vs Funds
Besides risk, cost is also something to consider when you are trying to decide between stocks and funds. When you buy an individual stock you might pay a commission when you buy and when you sell the stock but that’s about it. As you’ll see in the section on “where to buy stocks and funds” that cost is usually minimal. But with individual stocks, you won’t pay any additional fees unless you hire a money manager to manage the stocks for you.
But when you buy a fund or ETF, you incur additional costs. You might have to pay a commission when you buy or sell as well. But even if you don’t, you will still have to pay ongoing management expenses. Depending on the fund you buy, you could pay as little as .07% per year or as much as 3% per year. For a full understanding, you need to read through the particular fund’s prospectus.
Why do funds charge ongoing fees? Well, first because the fund company wants to make a profit. Without collecting money from the investors, they can’t make that profit. They have to charge you in order to stay in business.
Second, funds have expenses associated with managing money. For one thing, they have an investment committee which decides which stocks to buy and which to sell. The investment committee takes the burden of making investment decisions off of your shoulders which is great, but they have to be paid.
That’s why funds charge fees. Some funds are managed very actively; they buy and sell frequently. That frequent trading costs money so they generally charge higher fees. Those funds that are more passive and trade less typically charge lower fees.
The Importance Of Fund Fees
My experience tells me that fees are important but maybe not the way most people think they are. While you might expect the funds with the lowest cost to perform the best, that isn’t always the case. Need proof? Check out the highest performing funds in any given period. They are rarely the least-cost alternative.
Look at the following chart:
This shows the expense ratios of the 10 best performing large-cap growth mutual funds (net of fees) for the 10 years ended 9-2016 in order of performance. Yes, the lowest cost fund on this list performed best, but the second cheapest fund (charging .87%) was the 9th best performer. And by the way, there are plenty of funds that charge less than .49% that didn’t even make the list at all.
Why is that? It’s because fund performance is more important than costs.
Why aren’t there any super inexpensive funds on the list? There are plenty of funds that charge less than .1% per year. Where are they? If the cheapest fund there is charges .07% per year but underperforms the higher cost .49% fund by 2% over this period, is the cheaper fund a good deal? No. Granted, nobody can point to a fund and tell you that it will be one of the best performers over the next ten years. But if we look at the lists of the top performers and rarely see a cheap fund make the cut, it tells you something; right?
Oh….and one more thing. Performance is quoted net of all expenses. And if the goal is making money to achieve your financial goals without taking undue risk, shouldn’t performance be the determining factor? Of course it should be. That said, fund performance, risk and your investment strategy are far more important than fund costs alone.
Bottom line? It’s important to understand fees but they should not be your only criteria for selecting how to invest.
Do funds make more money than stocks?
This is a question I get asked all the time and it’s hard to answer because it depends on which funds and which stocks you are talking about. If you are good at picking stocks and enjoy it, you will likely make more money with individual stocks. However, it’s important to keep in mind that with individual stocks you have to do your own research. Also, keep in mind that if you go this route, you should plan for an ongoing time commitment to manage your stocks.
That’s because things change. You may not want to buy a stock and hold on to it forever. Stocks that are doing well today could go south tomorrow. That’s why it’s critical to have a strategy to manage your stock portfolio that tells when to buy and when to sell rather than simply buying stocks that are popular at any one time and holding on to them forever.
The bottom line is that many people find it more efficient and less risky to buy stock funds or ETFs rather than individual stocks.
Which mutual funds are best?
The answer to this question depends on your investment style and strategy. Also, keep in mind that all mutual funds are not alike. There are bond funds, stock funds, international stock funds, large cap funds, small cap funds, value funds, growth funds etc. The list goes on and on.
To make matters more complicated, there are passive funds and active funds as I hinted at above. Passive funds buy stocks held in an index (like the S&P 500) and hold on to those stocks until the index itself makes changes. (That usually happens about once a year). Actively managed funds trade stocks much more frequently as I mentioned above.
ETFs and Index Funds
I’ve been using the terms “index fund” and “ETF” interchangeably for a while now. But let’s take a little closer look. An ETF (Exchange Traded Fund) is very similar to an index fund. They often just replicate the holdings in the index and they do very little trading . That keeps costs very low.
There are some minor differences between index funds and ETFs however. The main difference is that ETFs trade like stocks and are priced during the day. For most investors, the differences between ETFs and index funds aren’t that important.
Before You Start Investing
Now that you have a solid understanding of how investments work, we’re almost ready to invest. Keep in mind that I don’t know your unique situation or risk tolerance. That’s why this guide is going to provide general guidelines for you. Before you implement these ideas I strongly suggest you speak with your financial advisor.
Investing Is NOT Just About Making More Money
Smart investors know that investing is not just about getting the highest return possible. What you want to do is balance your financial goals with your emotional well-being. It makes no sense to invest super-aggressively if it keeps you up at night. On the other hand, if you invest too conservatively, you may not reach your financial goals.
How do you find the balance?
My suggestion is to first get an objective assessment of your risk tolerance. One way to do that is to take this or another risk survey. This will provide an introspective look of what kind of investment mix you might feel comfortable with.
Then, test your comfort zone against your financial plan. Does this kind of asset mix have a high likelihood of helping you achieve your goals? You will only know this if you run your retirement projections – and that’s why it’s a must.
This takes a little work. Most DIY investors skip this step and in my experience, it’s the reason many fail. Please don’t repeat their mistake. What good is it having a portfolio you feel comfortable with if it doesn’t have a high likelihood of getting you where you want to be? Let me show you a crazy analogy to prove the point.
I might feel really safe sitting in a tank. But if I can’t use it to drive down to the Food Mart to pick up groceries (or anything else) what good is it? You get the picture. Investing is all about compromise.
Once you test your risk appetite and run it against your financial plan, you’re just about ready. I want to offer one piece of advice; I suggest that you start off being a little more conservative than you think you should be and monitor yourself over a period of time. In fact, stay tad conservative until the market goes through a rough patch or two.
You really know what your risk tolerance is once the market turns ugly. If you can stomach it, that’s fine. You might consider becoming even a little more aggressive. But if you can’t tolerate the swings, lighten up on the equities and put a heavier emphasis on fixed income as long as the renewed allocation jives with your long-term goals.
The Last Filter
Now that you know what your risk tolerance is and what your long-term goals are, the next thing you should think about are your priorities. Are you in debt? Are you going to buy a house or spend a lot of money in the short term? How far away are you from retirement? As you’ll see, your investment plan should be customized to accommodate these very unique circumstances:
How to invest if you are in debt.
If you have significant credit card or personal debt, address that problem before worrying about investing. This is important for two reasons. First, the interest you are paying on those debts is likely far higher than any guaranteed return you could make by investing. And second, if you don’t take care of the debt problem, it will probably grow. And if it grows, you may have to liquidate your investments at some point to pay off that debt anyway.
If you have mortgage debt, car and/or student loans, you might be OK investing while paying those debts off but if the rates on any of these debts are higher than 4% – I would personally pay them off before investing. That’s because when you pay off a debt it’s a guaranteed return.
In other words, if you pay off a creditor that is charging you 4%, that means you’ll be saving a guaranteed 4% . That’s the same as earning a guaranteed 4%. The higher the rate on debt, the more profitable it is for you to pay it off before doing anything else.
How to invest if you are just starting to put money away
Let’s assume you have no substantial debt, you’ve already set up your emergency fund, and you’ve got money to spare each money that you want to invest. Let’s further assume that your main financial goal at this time is to save for retirement (we’ll talk about other goals and how to invest to achieve those goals in the retirement guide).
If that describes you and you have retirement plans at work or are able to set up your own IRA or other retirement plan, that’s where you want to sock that cash away. You benefit most by adding as much money as possible to retirement plans because of the tax benefits of doing so and because these plans keep your money safely invested so you can’t spend it. (When we get to the retirement guide, we’ll discuss the differences between the types of plans.)
For example, if you have a 401(k) plan at work and are eligible to contribute $500 a month to that plan, do it. (If you have another $500 (or whatever amount) you are not allowed to put into that or any other retirement plan, you should invest that money for long-term growth in a non-retirement plan (non-qualified).)
How to invest if you are more than 10 years away from retirement.
If you have a decade or more before you plan to retire, you’ve got time and it’s important to use it wisely. Believe it or not, your time is just as important (if not more so) than your money.
As described above, determine what your risk tolerance level is. Then run yourself a few retirement projections to determine what you need to do in order to achieve your financial goals.
In most cases, that will likely include investing for growth – at least partially. In case you think that your investment time frame is short because it only extends to your retirement date, here’s a key success nugget that most people overlook.
You have a lot longer to invest than you think. Let me explain this by way of example. Let’s say you are 50 years old and you want to retire at 65. Do you have 15 years to invest? NO. You have decades more. That’s because if you are like most people I know, you want your money to keep working after your retirement date.
In fact, you want your money to keep working as long as you live – at least. That’s the key; when you think about investing, think about how long you want your money to last/work for you rather than your retirement date. Indeed, your retirement date isn’t that important when it comes to deciding how to invest.
If you are 50 years old today and you want to retire in 15 years, you probably still want that money to work another 25 or more years after you retire. If that’s the case, you have a 40 year time horizon, not 15.
So your first step is to be crystal clear on what you want your money to do for you and for how long. Once you know the answers to these two questions, invest accordingly. Again, balance your risk against your long-term needs and invest in a way that provides the greatest chance of you achieving your goals with the least amount of risk.
How to invest if you are less than 10 years from retirement
If you are less than 10 years from retirement, you might think you have to invest very conservatively. Well…you might. But you might not. Please read the two sections above. They are important and provide the necessary background you need. What I’ve explained above should help you hold on to the right mindset while understanding your real investment time-frame. If you read between the lines, I’m saying that your retirement date isn’t necessarily that important in determining how to invest.
Think about investing from the standpoint of how long you want your money to work for you. Remember that just because you retire, doesn’t mean you can afford to allow your money to do so. Inflation marches on regardless of what you do. That being the case, resist the temptation to become too conservative.
How to invest if you are retired
Retired people still have long investment time horizons. Focus on your expected longevity and (more important) the desired longevity of your assets. I realize that’s not always so easy to do but it is important. The problem here is that when people stop working they often become hyper sensitive to short-term fluctuations in their investment accounts.
I understand this. It’s only natural. Since you aren’t working, it becomes more important than ever to protect your capital. I get it. But as we’ve discussed, investors who become over-cautious often jeopardize the long-term safety of their retirement accounts in order to minimize the short-term risk. This is a very bad and expensive trade-off.
The solution is to revisit your risk tolerance and test again. Once you do that, re-run your retirement projections as well. Invest using an allocation that exposes you to the least amount of risk as long as you still have high probability of achieving your goals.
How to invest if you are way behind.
People who haven’t saved enough for their retirement are often anxious. They sometimes feel compelled to invest too aggressively. In their minds, they do this in order to “catch up”.
I understand this of course but I caution you against being too aggressive if you find yourself in this camp. The reason is, people who take on too much risk lose money over the long-run in my experience. They get involved with speculative schemes and risky ventures.
Remember, even if you are behind, you probably still have a number of years to make up for it. And when we speak about retirement investing, it is by nature a long-term deal.
You will take far too much risk if you speculate. Don’t give in to that impulse. Instead, slow down and breathe. Revisit your plan and consider adjustments such as delaying retirement, working part-time and/or spending reductions.
My strong recommendation is not to compromise when it comes to investment strategy. Do not get in over your head or invest aggressively. The odds are definitely not in your favor if you fall into that trap.
Investment Strategies To Consider
I’ve already explained how different investments work, now let’s consider different approaches to investing. This is important stuff. It’s far more important to get your approach right (for you) than to pick one or two good funds or stocks at any one time. That’s because if you get the approach right, it’s repeatable. But making a lucky call once in a while isn’t something you can count on.
There are three different strategies that most people use. My goal is to help you make smarter decisions based on your understanding of these approaches to make more money over the long-run and have a lot less stress starting now.
But keep one thing in mind. No matter how you invest, please don’t expect stellar results all the time. And prepare yourself for losses. That’s just the price we pay to achieve our long-term goals.
With this in mind, there are a few ground rules that we need to establish. These rules are basic and the foundation on which to build a successful investment approach:
- Nobody can predict the future.
- You can point to any investment strategy and “prove” it’s either great or terrible by manipulating the time frame. What matters most is the long-term results and accompanying risk.
- Behind every investment pick there is an investment strategy and the strategy is what we’ll discuss – not the stock or fund pick.
- Before investing make sure you understand your time-horizon.
With these fundamentals clear, let’s establish a few rules:
Rule #1. You aren’t allowed to try to predict the future or listen to someone else who does.
Rule #2. You aren’t allowed to change your investment time horizon just because the market or political situation changes. Obviously, if your personal situation shifts, you’ll have to adjust your investing strategy. But if you shift your investments based on nothing more than your feelings about the economy/market/whatever, that’s just breaking Rule #1.
Rule #3. You can’t win them all. Every decision has its benefits and drawbacks. You have to accept that you will suffer losses in order to gain the long-term benefits of any investment strategy you employ.
You might be telling yourself that these rules are all self-evident. And if so I congratulate you. But before we accept that, let me ask you a few questions just to make sure:
Have you ever changed your long-term investments as a result of a political, economic or historical event because you “knew” the market would melt down as a result? If so, you broke Rule #1.
Have you ever read about a very promising new stock and bought stock based on their very bright future without doing any research? Or have you ever said, “I know the market will never come back from this” and sold out? If so, you also broke Rule #1.
Have you ever complained about the low interest that banks pay? That’s breaking rule #3. You wanted the safety of the bank but aren’t willing to accept the downside – low interest.
You see? Adhering to these rules isn’t easy – but necessary if you want to achieve long-term results. Using these three rules, we’re going to proceed and take a deep dive into three investment methods: asset allocation, buy and hold and timing the market.
You probably already understand the benefits of not putting all your eggs in one basket, right? If so, you understand the basics of asset allocation. Yay!
People who invest using this concept have a variety of different funds in their account representing different indexes or areas of the market like large cap, mid cap, international etc. But since asset allocation calls for having fixed percentages of their account in specific parts of the market, these investors have to tweak their holdings periodically.
Let me clarify this by way of example. Let’s say your asset allocation model calls for you to hold 10% of your account in large cap index funds, 10% in international and the other 80% in various other funds and that you start with $100,000. That means you’d invest $10,000 in large cap and $10,000 in international and $80,000 in other funds.
Assume that by the end of the year, large cap did particularly well relatively to your other positions and is now worth $12,000. If the total account value is still $100,000 at the end of the year, it means you have 12% in large cap and that’s too much.
Going back to our example, assume that international, is only worth $8000 and makes up 8% of the total account at the end of the year.
If you were an asset allocator, you would sell off $2,000 of the large cap and buy $2,000 of the international fund to bring the holdings back into line with your 10% targets.
If you noticed, using this approach, you sell high and buy low. Selling off some of the positions that do well (which appreciated in price) and buying other positions that fell in price and are cheaper. Asset allocators invest this way because they feel that nothing does well forever and it’s impossible to predict when any one index will do better than the other. This technique takes all the guess work out of investing because it has lots of eggs in lots of different baskets and they are constantly being updated.
Asset allocators might hold bond funds, real estate funds, commodities etc. It depends on how much risk the investor is willing to take. The more aggressive you want to be, the more you would skew your allocation towards equity. If you are interested in taking less risk, you might put more in fixed income.
Does Asset Allocation Work.
According to Wikipedia, during the 2000 – 2002 bear market, an investor who had 80% in stocks and 20% in bonds lost 34% while an investor with the inverse allocation made 6%. This makes sense. A person with a more conservative portfolio will do much better during very bad markets. Duh.
Now let’s look at 2008 and see how asset allocation funds did:
As you can see, asset allocation didn’t help investors that much. The overall fixed allocation (how much in stocks, how much in bonds) did help. But the periodic rebalancing did not really add value – at least in this case.
Asset allocation funds are designed to protect investors against steep losses but you can see that they don’t always do the job. That doesn’t mean they are bad funds. It means the concept isn’t foolproof.
Of course nothing is perfect. And no investment strategy will work every single time. And it doesn’t make sense to decide about your investments only from the “worst case” standpoint. That would have you keep all your money in the bank and probably not achieve your goals.
The real benefits of asset allocation are that they take the emotions out of the process, it leads to a diversified portfolio and can help protect investors from losses at times. But there are also downsides.
First, many investors are under the impression that asset allocation shields them from danger and risk and that’s just not true as we saw above. On top of that, this approach sells off the strongest funds and buys the weaker ones. I prefer to buy more winners and sell off losers. That’s why I’m not a big fan of asset allocation with static percentages. Let’s move on.
Buy and Hold
Buy and hold sounds simple enough; You buy an investment – you hold on to it. That’s it. What could be simpler than that?
Well, there is more to this than meets the eye. Let’s explore so you can really understand the pros and cons of this style of investing. For our purposes, we will use the S&P 500 index to demonstrate. (As I explained above this is an index made up 500 American stocks with the greatest market value.)
A Big Problem With Buy and Hold
Lots of people say they are buy and hold investors. The problem is, very few people can actually do it. Buying is easy. Holding is the difficult part.
That’s because at some point, people’s emotions get control over them. As a result, they make emotional decisions and override their “buy and hold” strategy. Often, this happens at the worst possible time.
To understand better, please review the following chart:
This shows that when times are hard (as depicted in the first column) it’s really tough to focus on the long-term. Look at 2008. Most people were thinking about 39% loss instead of the 25-year average gain of 9.61%. That’s natural. I get it. But it often leads to decisions that make your financial situation far worse.
At this point, I think it would be helpful to remind you of our 3 investment rules:
Rule #1. You aren’t allowed to try to predict the future or listen to someone else who does.
Rule #2 You aren’t allowed to change your investment time horizon just because the market or political situation changes.
Rule #3 You can’t win them all.
Buy and holders often find it difficult to honor these rules when the market hits a rough patch and that’s why the strategy fails. When times are good, it’s easy to have a long-term view. But when the bear market hits, people often shift their time frame (see Rule #2), decide that the market is going to continue falling (see Rule #1) and forget that every investment fluctuates in value (see Rule #3).
Consider the rolling 10-year periods over the last 75 years. The market has gone up 95% of those 10-year periods. So, if you are investing over a 10-year period, isn’t buying the S&P prudent? Of course it is. Even though 5% of the time, the 10-year hold lost money, so what? Should you build your future with the odds in your favor (95%) or should put everything on the line based on the 5% outliers?
Buy and hold can work in theory. But I believe that the emotional build-up is too great a force to overcome for many investors. In other words, this approach doesn’t fit most people’s mentality. Let’s consider a third alternative that might.
Many investment professionals will tell you that market timing is risky and doesn’t work. For the most part, they are right. But it depends on how you define “market timing”. In my experience, there are strategies which, when employed correctly, may help reduce risk and grow your wealth.
Let me clarify. When I say, “market timing” I am not talking about day trading. I’m talking about using objective data to determine when risks are higher (and therefore a good time to become more conservative) and when opportunity is greater (and therefore a good time to become less conservative). This might mean changing your portfolio once a month or once a year – it depends on your technique.
At the same time, it’s important to remember that even the best techniques won’t shield you from losses all the time and they won’t beat the market all the time either. This is true no matter how you invest.
Let’s take a moment and revisit the purpose of this exercise; to help achieve your long-term goals over the long-term, with the least risk possible. This is not about short-term performance but long-term fulfillment.
And before we dive in too deeply, I want to differentiate between adjusting your portfolio based on your gut feeling (see Rules above) vs. using objective, measurable data. If you are going to get in and out of the market based on how you feel when you wake up in the morning, I can’t help you. However, if you can stick with a formula to guide your investment decisions based on objective data, you could be going in the right direction.
For example, below is a hypothetical simple moving average system. You buy when the S&P rises above a moving average and you sell when the market drops below its average. You can see that over the long-term, this hypothetical system has rewarded investors richly.
However, this is hypothetical and is not based on real experience. I am only showing this example to explain what market timing is and how it might be used. Also, this hypothetical system beat the market for many years but it didn’t beat the market every year. There were times where this method did worse than the market. There were also years where you would have lost money had you used this technique to guide your investment moves. And there were years when those losses were substantial. Of course, the past is no guarantee of future results.
Again, you have to keep our third rule in mind – there is no free lunch and nothing is perfect. In other words, there are timing systems that have done better than buy and hold over the long-run IF the investor was able to stick to the system. Often, people can’t.
When you are agitated (either because of external events or because of your personal situation) it’s easy to shift your time frame, think you know what’s going to happen and reject the notion that sometimes as investor, you have to go through hard times.
Market timing isn’t for everyone. It may not be for you. And if you do go this route, please expect that there will be periods of underperformance and losses as I said. It may also involve spending more time and learning by trial and error or hiring someone to do this for you. But as we saw above, the right approach could deliver when it comes to risk reduction and help you achieve your goals over the long run.
Which approach is right for you?
For most of us, investing isn’t an option; it’s a requirement if we want to ultimately achieve our long-term financial goals. Unfortunately, every approach has its flaws.
Asset allocation can help reduce risk on the macro level but it can also lull investors into a false sense of security thinking that they are safer than they really are.
Buy and hold can work well theoretically but usually fails because emotions often overtake investors who break the 3 rules and end up on the short end of the stick.
Market timing tries to bridge this gap. On the one hand, it can help you grow your money and it may also help protect your assets when the market demonstrates weakness. But on the other hand, this is no guarantee of future results. You probably will underperform using this system during certain time frames. There is no way to escape this.
Still, for many people, this is an easier route because they know that they have a safety valve and don’t have to sit there and watch the red ink pile up. Knowing they have a mechanism to steer them clear of potential trouble may help investors hold on just long enough to avoid falling victim to their emotional selves and that is often our greatest financial hurdle.
In order to determine the best approach for you, revisit why you are investing – probably to achieve long-term goals with as little risk as possible. If you think you have 10 or more years to live, we’ve seen how important it is to consider inflation. And if inflation is important, we should consider equities as a potential tool to combat that problem.
Bottom line? If we are resigned to the fact that we’re going to need equities in our portfolios, we have to also be ready for tough times. If you are very interested in avoiding all risk, determine how much you need to invest in equities at a bare minimum and consider an asset allocation strategy that exposes you to the least allocation to stocks you can find that still allows you to reasonably expect to achieve your goals.
If you are the kind of person who never looks at their investment statements, buy and hold might be your ticket. Just remember to dust off your statements at least once a year and re-evaluate your holdings.
If you are very focused on making sure you take the least amount of risk possible while growing your money safely, consider market timing as I’ve defined it. You may want to do this yourself or hire someone to do this for you as I suggested. Just remember that nothing is perfect and no matter who invests or how they do it, there are times that will involve losses.