It’s easy to get sucked into the trap of trying to buy or sell investments to avoid crashes and maximize gains. Below, we show why this approach is little more than gambling.
Financial planners often counsel their customers to “set it and forget it.” What they mean is that investors should buy investments and then all but forget they have them for many years.
Easier said than done. When someone’s life savings is on the line, the temptation is great to log in and check the account balance every day and watch the ups and downs of the stock market like a castaway staring down circling sharks. Also tempting is paying attention to the constant stream of TV pundits and articles exhorting investors to head for the hills and that the next crash is just around the corner, or telling them to relax and buy more and that everything is fine. The Jim Cramers of the world are exciting and there’s something to be said for the adrenaline or fretting about whether the natural gas glut or the new Apple Watch will offer a buy or sell opportunity an investor shouldn’t miss.
1. Set it and Forget It Works Best
The truth is, most everyday investors just don’t have the time or the resources to pick stocks and choose buy/sell times correctly. Billionaire investors like Warren Buffett make it work because they make it their full time job – and a lot of other people’s full time jobs – to know everything it’s possible to know about thousands of companies.
Knowing whether a particular stock is a good deal or not and whether now is the right time to buy or sell can mean huge profits, but it also takes a phenomenal amount of information about a lot of companies. Unless someone’s going to make investing their full time job, they stand to be out-competed by thousands of others who do have the time and the resources to really dig into the data.
2. Knowing When Stocks Will Soar or Crash Isn’t Possible
Everyone knows the old adage: “Buy low, sell high.” The problem is, how do you know when a stock is high or low?
Trying to figure out when a stock or the entire market will boom or bust is called “market timing.” The idea is that figuring out when investments will rise or fall will let investors get in at low prices and get out at high prices, giving them the highest returns possible.
Trouble is, trying to get the timing right is little better than gambling. A financial research firm called DALBAR found that in the last 30 years, the typical individual investor earned about 3.7% per year, while the S&P 500 as a whole saw returns of 11.1%.
3. The Dow Jones Upward Roller Coaster Works Despite the Downhills
There’s no denying that stocks lose value. Sometimes they lose it the same way a rock thrown off a cliff loses altitude. Looking at the performance of the Dow Jones Industrial Average over the past 40 years, it’s not hard to find times when the market dropped 35% (2001) or even 53% (2008). Anyone with $100,000 in a fund tied directly to the market’s performance would’ve had only $65,000 left after the first crash or $47,000 left after the second.
However, in spite of both of those admittedly gigantic crashes, someone who put $100,000 in a fund tied to the DJIA in 1995 and left it alone would have had approximately $445,000 by 2015, just 20 years later.
The table below shows a crude approximation of the value of a $100,000 investment tied to the DJIA in 1995. The figures aren’t exact, because smaller fluctuations in the market would also alter the investment’s value. But the table does serve to illustrate the point that despite the huge crashes, broadly-based investments in the market have historically done well over time no matter the ups and downs, as long as an investor didn’t panic.
"Hands Off" vs "Hands On" Stock Investing
|Year||DJIA Change||Investment Tied to DJIA||Panicky Investor|
|2000||up 270% since 1995||$270,000||$270,000|
|2002||down 35% since 2000||$175,500||$175,500|
|2007||up 200% since 2002||$351,000||$175,500|
|2009||down 53% since 2007||$164,970||$166,199|
|2015||up 270% times since 2009||$445,419||$166,199|
4. Panicking Sinks Stock Market Investments
By contrast, those who panic when the stock market drops tend to “sell low, buy high,” selling out just when the stock market is low and then buying back in again when they see everyone else making tantalizing gains. Even those who panic and pull out when the market crashes, then enter back in to try to join in on huge gains, still generally make money. In the table above, the final column shows the gains of an investor who pulls out during a crash and then re-enters the market only when gains are solid. Even that investor has turned $100,000 into $166,000 after 20 years. However, his returns are a far cry from the gains of the investor who just “set it and forget it.” That’s about a 2.6% annual gain, compared to the 7.8% annual gain of the non-panicked investor.
It’s interesting to note that even though investor #1 had less money in 2009 than she did in 2002, she still winds up ahead in the long run just by leaving her investments alone. She probably sleeps a lot better at night, too.
Relaxed Stock Investing is Like Relaxed Driving
There’s a great scene from the movie Office Space where Ron Livingston is stuck in traffic. He keeps trying to get into the fast lane, but every time he does, the fast lane traffic grinds to a halt and the lane he was in suddenly starts moving. The clip below is just a loop, but in the full movie version, Livingston eventually looks up to see that he’s being passed by an old man with a walker on the sidewalk. This is about as good a metaphor for trying to time the market as it gets.
Even those who don’t make the gigantic mistake of selling at the bottom and buying at the top but time the market marginally better still don’t tend to do well over time. That’s because they miss out on gains and take on too many losses compared to the relaxed investor.
Be Warned That Historical Stock Investment Performance Doesn’t Guarantee Anything
Just because $100,000 invested in 1995 and tied to the DJIA would have been $445,000 by 2015, that doesn’t mean that’ll happen in the future. There are also other considerations that should make investors cautious.
Financial planners generally say that anyone who needs to use their money in the next three to five years shouldn’t invest it in the stock market. While the gains from diversified stock investing have historically been very high long term, anyone who put $100,000 into a fund linked to the DJIA in 2005 and then planned to retire in 2010 probably got a nasty shock. Five years simply wasn’t enough time for their losses to come back from the crash.
In the case where someone needs to use their money in the short term, good alternatives are high yield savings accounts and CDs. While they only earn about 1% to 2% compared to the stock market’s 6% to 10%, there’s vastly less risk that money in CDs or savings accounts will shrink by 30% to 50% in the short term.
Diversification and Stock Investments
Even someone who doesn’t need the money short term can generally benefit by spreading their investments around. Financial planners usually recommend that an investor’s money be split between a little cash, some stocks, some bonds, and some foreign investments. The thinking is that when stocks drop, bonds usually go up, though this isn’t a hard and fast rule. Likewise, when U.S. investments drop, foreign investments can rise, softening the blow.
Savings Accounts Used to Be a Good Alternative to Stocks
Up until fairly recently, savings accounts were a good alternative to investments in the stock market. Savers could generally earn about 5% interest, largely risk free, by putting the money in a savings account. Sadly, those days are gone, at least for now. The typical savings account in the U.S. only generates about .01% interest. That would yield only $9 for a $10,000 savings over ten years.
Article Source: 3 Reasons Market Timing Doesn’t Work – The Motley Fool