Why trying to time the markets tends to be a losing proposition
The average investor's return is significantly lower than market indices due primarily to market timing.
— Daniel Kahneman
Timing the market means buying or selling based on trying to predict economic trends. While it may seem like an easy enough concept, using this technique isn’t a winning investment strategy. In fact, if you sell at the bottom and sit on the sidelines in times of trouble, the anxiety of being in volatile markets is replaced with the anxiety of being out of the markets. Have they bottomed? Is this just a bear market rally? A dead cat bounce? Is this the recovery? It’s impossible to tell. But there’s a strategy that removes the anxiety of picking the perfect time to invest: dollar-cost averaging.
Just for argument’s sake, let’s say that it’s possible to buy at the perfect time every year — even though the odds are stacked firmly against doing this in any year, let alone every year. Mr. Right picks the perfect entry point for his capital year after year. Mr. Wrong has the other side of this equation. Although it would be just as hard to do, Mr. Wrong manages to pin down the worst day to invest every year.
Comparing the two, we see that they’re actually not that different, which leads us to the conclusion that it’s time spent in the markets, not timing the markets, that tends to generate returns. The biggest difference in the compound annual growth rate between the two investors for any given year in the market is about two per cent. If we look at the third investor, Mr. Consistent, who invested on the same day (Dec. 31) every year — no matter what — the difference is even smaller.
Committing during volatile times
During times of economic volatility, it can be daunting to commit capital. But as was highlighted above, the difference between the best day and the worst day is negligible, and buying on the same day every year closes the gap on Mr. Right.
To completely remove the guesswork of committing one lump sum at the perfect time, consider a dollar-cost averaging strategy. By investing a smaller amount each month or quarter the price of the investment will be smoothed over the year. Just as Mr. Consistent split the difference between Mr. Right and Mr. Wrong, investing equal amounts every month or quarter has the same effect. When markets are climbing, the same amount will buy fewer units. When the markets are lower, the same amount will buy more units. The result? The average cost per unit is lower than committing a lump sum at any one point in the year.
Dollar-cost averaging in action
Here’s a simple example that shows how a systematic investing plan can benefit an investor.
Let’s say Janice commits to investing $100 in an equity mutual fund every week. As it happens, the markets are especially volatile over the next two months:
Cost per unit
|Number of units purchased|
|Total amount invested: $800||Average cost per unit: $9.26||Total units purchased: 86.4|
For illustration purposes only.
Over the eight weeks, Janice invests $800 and buys a total of 86.4 units. Her average cost per unit is $9.26 and, although the cost per unit is lower in week 8 than it was in week 1, the total value of her investments is $800.06. Despite significant volatility, she breaks even.
It’s true she could have done even better if she had somehow known that week 3 was the best time to buy when the cost per unit was at its lowest — her $800 investment would have bought 114.3 units, worth $1,028.70 by week 8. However, she could also have done much worse if she had wrongly guessed that week 6 would be the best time to buy, when the cost per unit was at its highest — her $800 investment would have bought just 66.7 units, worth $600.30 by week 8.
Even the most skilled professional investors can’t say with certainty when a stock has bottomed out or peaked, so a systematic investing plan is much less risky than trying to time the markets. Averaging out the cost per unit over time, so that fewer units are purchased at high prices, can help investors get more from their investments.
Balance it out for a smoother ride
Combining dollar-cost averaging with portfolio rebalancing can offer stable footing, especially during times of market volatility. A portfolio with a 100 per cent equity strategy may be considered a bit too high risk for many investors, but a balance of a 60/40 equity to fixed income strategy may feel a bit more reassuring. The graph below shows a 60/40 portfolio versus a 100 per cent equity portfolio. As you can see, the balanced portfolio performs well during down markets. It doesn’t quite keep up in times of outstanding equity market returns, but over the long run, it keeps up with the 100 per cent equity portfolio with the added benefit of more downside protection.
In a recent Viewpoints article on portfolio rebalancing, the case was made that frequent rebalancing is like a dollar-cost averaging strategy. When equity markets fall, rebalancing back to the chosen asset allocation naturally takes advantage of underpriced equities. Same thing on the flip side. As equities build a head of steam, taking profits and rebalancing back to 60/40 takes advantage of lower-priced fixed income securities.
There are many risks during volatile times and keeping it all “under the mattress” may feel like the right move. Dollar-cost averaging new capital into the markets can be the solution to the lamentations of “missing the bottom” or “buying at the top.” History shows us that having a balanced portfolio may not see the highs of a pure equity strategy, but the downside protection and the ability to rebalance when one asset class becomes inflated is worth considering.
Source: Manulife Investment Management