Friday, August 28, 2015

Time In The Market Trumps Timing The Market For The Long-Term Investor

It’s funny. Add just a smidgen of volatility to the stock market and people go crazy.
The last few days of last week proved to be a little volatile for the stock market. Oil prices are at multi-year lows right now. Questions about global growth, China, and Greece continue to dominate headlines.
But does any of this really matter for a long-term investor? 
Not really.

Let’s Keep Perspective

If you look at the S&P 500’s price change over the last five years, it looks almost like a straight line up. The broader market is up almost 84% (before dividends) over that time frame, which is an incredible run coming off of the the financial crisis. As I recently discussed, the broader market appears overvalued right now. Although, many stocks within the market appear to actually be attractively valued.
Moreover, the broader market is down a little over 4% on the year. A correction across the board still hasn’t come to pass – the market is down something like 7% from recent highs. These are very small numbers. So if the recent volatility frightens you, now would be a really good time to figure out whether stocks have a major role to play in your asset allocation. Stocks aren’t for everyone.
Now, when you read headlines like “Stock market endures worst day in 18 months“, it makes sense to keep perspective. I mean we’re talking about a little volatility here in what has otherwise been more than five years of almost relentless increases across the board.
But the short term can be scary, even for a long-term investor. No one knows where the prices of stocks are going to be tomorrow.
But would this foreknowledge be helpful if you could have access to it? We all know timing the market isn’t possible, but what if you could time it? What if you had $20,000 to invest right now, but wanted to make sure you bought in after a major drop (should one occur)?
Turns out it doesn’t make that much of a difference over the long haul…

Black Monday

Black Monday. October 19, 1987.
The Dow Jones Industrial Average fell 22.61% on that one day.
Now that’s volatility.
So let’s say you had that same $20,000 (which would have been worth a lot more) to invest back in 1987. And let’s just say your best friend had a crystal ball. And that crystal ball told you that things were going to get really crazy on October 19.
You could have gone about it a number of ways. You could have invested in the S&P 500 (through a broad-based index fund) immediately after the drop. You could have spread that capital across any number of high-quality stocks that pay and grow dividends (what I’d do and am currently doing). You could have even bet large on one company.
Let’s take a look at what that would have done for you over the following 28 years.
Let’s say you decided to put all $20,000 in the Vanguard 500 Index Fund (VFINX), which is an index fund based on the S&P 500. And let’s say you gave it one day for things to cool off and put all $20K in on October 20, 1987. If we fast-forward to August 21, 2015, you’d have $293,128 sitting there for you. That’s an annualized return of 10.12%. Boy, you’d owe your best friend a lot of money, right?
Not quite.
Compare that to the person who lacked a crystal ball and decided to invest all $20K in VFINX the very Friday before Black Monday, on October 16, 1987. Just imagine the feeling in that person’s stomach when they woke up Monday to find out that their investment just took a major haircut. Well, this is where time in the market comes to save the day.
That same $20K invested in VFINX on October 16, 1987 would currently be worth $245,530. That’s an annualized return of 9.42%.
A difference of almost $50,000 shouldn’t be understated, but what do we see here? We see someone whostill did incredibly well. An annualized rate of return still near 10%. While I’m not factoring in taxes or inflation, I also factored in the fact that someone would invest all of their money all in one day, and that day happened to be the very day before one of the worst stock market crashes in history (the crash has its own name, after all).
But investing all of your money on the very worst day possible is highly, highly unlikely. It’s far more likely and reasonable to assume that you’re dollar cost averaging your way into stocks. And this smooths the results out even more, to the point where timing the market is almost negligible.
Time in the market is more important than timing the market because you have control over time in the marketMeanwhile, you can’t control timing the marketLonger periods of time provide an effect where short-term fluctuations almost disappear. The longer the period, the less short-term fluctuations show up.
And over long periods of time, high-quality dividend growth stocks tend to appreciate at an attractive rate while also growing their dividends well over the rate of inflation, increasing one’s purchasing power. That attractive growth rate over the long term can and does make up for poor short-term timing.
Take a look at Johnson & Johnson (JNJ) using the same dates and capital above. For the person who had access to their friend’s crystal ball, they ended up with an annualized return of 14.14%. That led to an investment worth $795,615. The investor that timed the market horribly but decided to hold on for the long haul and stick to the plan ended up with an annualized return of 13.73% and an investment worth $721,340. This is assuming reinvested dividends.
You can see this play out over and over again with any number of stocks. One would do better if they had access to a crystal ball, but not that much better. And the longer we go, the less it will matter.
The key takeaway here is that one still does incredibly well over the long haul if they stick to the plan, even if they put their capital to work right before major volatility strikes. Buy quality, ignore the noise, reinvest the dividend income.

Dollar Cost Averaging And Spreading Your Capital Around

Now, it’s more likely that you’re going to be investing smaller amounts of money over a longer period of time. You’re likely going to be spreading that capital out across many high-quality companies. And you likely would have been investing both before and after the big drop.
Let’s break that $20K down over the course of a year (using totally random dates) and across 10 different stocks (that were known for their dividend prowess even back then) just to see what happens:
  • $2K invested in The Coca-Cola Co. (KO) on February 2, 1987 would have provided an annualized return of 12.21% and a total investment now worth $53,769.
  • $2K invested in Exxon Mobil Corporation (XOM) on March 25, 1987 would have provided an annualized return of 10.29% and a total investment now worth $32,339.
  • $2K invested in Johnson & Johnson (JNJ) on May 7, 1987 would have provided an annualized return of 10.31% and a total investment now worth $32,195.
  • $2K invested in General Electric Company (GE) on June 29, 1987 would have provided an annualized return of 9.11% and a total investment now worth $23,278.
  • $2K invested in Procter & Gamble Co. (PG) on September 9, 1987 would have provided an annualized return of 11.97% and a total investment now worth $47,227.
  • $2K invested in 3M Co. (MMM) on October 26, 1987 would have provided an annualized return of11.98% and a total investment worth $46,652.
  • $2K invested in Colgate-Palmolive Company (CL) on December 2, 1987 would have provided an annualized return of 15.25% and a total investment worth $102,512.
  • $2K invested in Consolidated Edison, Inc. (ED) on December 22, 1987 would have provided an annualized return of 10.21% and a total investment worth $29,496.
  • $2K invested in General Motors Corporation (GM) on January 13, 1988 would have resulted in an investment eventually worth $0 (assuming one held all the way to bankruptcy, which would be unlikely; and dividends would have provided for some positive return).
  • $2K invested in McDonald’s Corporation (MCD) on February 10, 1988 would have resulted in an annualized return of 12.79% and a total investment worth $55,079.
I hate doing backtesting like this because it’s easy to cherry pick certain stocks to make a point. But I think most investors investing the way I do now would be interested in stocks like the ones I listed above even back in 1987 and 1988. Many were part of the DJIA at the time and all of them had some dividend pedigree already. In the end, though, this is purely illustrative.
However, you can see what dollar cost averaging both before and after a major stock market drop looks like when the time frame is drawn out across almost 30 years. The total return across the entire portfolio is pretty outstanding, even factoring in the eventual bankruptcy of the old GM. This portfolio would now be worth $422,547. That’s more than had you invested in the S&P 500 on the day after Black Monday. And that’s assuming 10% of your portfolio eventually became worth nothing.
What I also see here is that quality matters more than anything else. Coca-Cola did very well for shareholders over the last few decades, even for those that bought in not long before Black Monday. But those who may have scored GM at a cheaper price after the crash eventually found themselves in a poor position. So value matters. But quality matters much more.

Conclusion

I don’t often put forth backtesting. I’m more interested in what the journey to financial independence looks like in real-time with real money. But I think it’s important to keep perspective whenever there’s some volatility in the market, and the illustrative examples used above helps further the discussion.
If you’re able to focus on quality, ignore the noise, reinvest your dividends, buy when the value is there, and hold for the long haul, your odds of achieving very satisfactory returns and growing dividend income over the long term are very good. For the long-term investor, time in the market trumps timing the market by a large degree. I take comfort in knowing that I wouldn’t do much better than I’m already going to do, even if I had a crystal ball that told me when the stock market was next going to fall substantially.
So stick to your long-term plan. Ignore the headlines that tell you the sky is falling. Don’t let Mr. Market bully you into making poor choices. Use short-term volatility as a long-term opportunity, because the long term smooths out short-term fluctuations. However, those short-term fluctuations can provide for even better deals on high-quality assets. It might seem scary at the time, but your future you will be in a much better position if you stay focused on time in the market rather than timing the market.
Full Disclosure: Long KO, XOM, JNJ, GE, PG, and MCD.
What do you think? Do you think time in the market matters more than timing the market? Is timing the market – an impossible task – worth the effort?
Thanks for reading.

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