Buy High Sell Low or Just Buy and Don't Sell?
Stocks are reaching new highs all the time and some are worried that markets are overheated. You might be hesitant to put your money to work in such a peak environment, but this post will explain why holding off investing can prove to be more detrimental than investing in equities at market tops, with an example from Ben Carlson, CFA and a simple chart from Fidelity.
Firstly, let's follow one of the worst investors over the last 40 years. To help, Ben Carlson, CFA, published a piece in 2014 entitled "What if You Only Invested at Market Peaks?". He used a fictional character named Bob and assumed that his career began in 1970 at the age of 22. Fictional Bob was saving $2,000 a year during the 1970s and increased the savings amount by an additional $2,000 at the end of every 10 years until his retirement.
Now, being one of the worst market timers, rather than investing his money in stocks straight away, he only invested in stocks when the markets had already gone up substantially. Sadly, Bob invested all his money only at market peaks. In the below table, you will find the investments of Bob and the gravity of the subsequent market crashes.
Dumbass, you might be thinking. Though, the one thing Bob did correctly was never selling his stocks even after seeing them crash the moment he got into them. As of February 2014, he would have turned his investment of $184,000 into a hefty $1.1 million. For this calculation, the assumption is that Bob invested all his money in an index fund that tracks the S&P 500 Index. Although Bob seems to be one of the dumbest investors, even he would have ended up with a decent lump sum to spend in his retirement.
The takeaway is that investing at market tops is not as scary as you might have initially thought. There are smart investors out there who are able to sidestep market crashes, but it's very rare to get both decisions right.
Now, let us look at the other side of the equation. There is no doubt that an investor who bought stocks only at market bottoms would end up with a much higher return than Bob. The question is, what if we miss a few good days in our effort to "time" the market?
Understandably, an investor would assume that missing just a few good days will not have a material impact on portfolio returns over a long period of time. After all, we are talking about years or even decades when it comes to investing, so what could possibly go wrong if we miss just a few days? To find the answer to this question, look at the chart below.
Growth of $10,000 invested in the S&P 500 Index from January 1, 1980 to August 31, 2020:
If you missed just the 5 best trading days in over 40 years, your final return would be 38% lower than what it would have been if you had remained invested in these 5 days. Imagine missing the 50 best days of the market and ending up with 93% less money than you would have had if you stayed invested.
The point is that market peaks or even volatility should not frighten you away from investing in the stock market. Diversify, compound and don't let your emotions sway your investment decisions.
Of course, it's imperative to have a plan and you should ask yourself a number of key questions including: What is your time horizon? (The longer, the better). What are your liquidity constraints? (Plan for events in the future whereby you might need cash quickly, and keep that in cash). What is your risk profile? (The answers to the first two questions can give you a general idea of what this would be).