Should you time the stock market?

One of the most common questions on financial forums goes something like this: “I just came into X amount of money, I’m afraid to just dump it into the market because I’m worried it will crash. What should I do?” Often, the windfall comes by virtue of an inheritance, a job bonus, or from proceeds after a real estate sale.

How to invest

First, as to the question of how to allocation your funds, there’s almost no good reason why you should allocate it any differently than you are already allocating your existing savings. By that, I mean that if you’ve previously decided that you are comfortable with an 80/20 stock bond split, with 25% of your stock being international, then that’s probably how you should invest this money.

Avoid the inclination to suddenly test the waters of pork belly futures, mining rights, or cryptocurrency if you weren’t already investing in those things before. That’s not to say that there’s no room for alternative investments, but simply that receiving a lump sum shouldn’t be a huge factor into your allocation.

Ok, here are a few exceptions: One would be that if it is a truly significant amount of money, such that you immediate become financially independent, then perhaps you may want to re-evaluate your asset allocation with a shift towards asset preservation, i.e., slightly more conservative. There’s a saying, “once you’ve won the game, stop playing.”

Or if you previously wanted to make a particular well-thought out investment (for example, real estate) but didn’t have the moneytogether, you now have that opportunity.

Finally, it’s completely reasonable to put a windfall towards paying down debt, which provides a guaranteed return. While your investments will likely generate taxable income, 4% annual interest saved off of debt is a real 4% annual return. The amount you gear towards reducing debt as opposed to investing will depend on the debt’s interest rate (5% or greater suggests putting more towards debt), whether carrying that debt brings any potential tax advantages (ex. real estate interest), and how debt-averse you are (Dave Ramsey vs. Robert Kiyosaki). Some would rather pay down a low interest loan even though they know that historically, they are very likely to beat that return had they invested.

For further reading on asset allocation, click here. For further reading on prioritizing investing/paying down debt, click here.

When to invest

Before, I talk about lump sum investing vs. dollar cost averaging, let’s talk about market timing in general.

Over the past 20 years, investors in stocks have lagged the S&P 500 benchmark by an average of 4.66% per year. Part of this is due to poor investment choices and high fees, but part is due to trying to time the market. Timing the market means trying to buy low and sell high. Sounds great right?

The problem is that it’s very difficult to time the stock market. You might remember the forecasts that the market would surely crash after Donald Trump was elected. Yet here is a snapshot of an S&P 500 fund from election day 2016 until 9/4/18.

But, what about the fact that it’s been X number of years since we’ve had a bear market. It’s time for a crash or at least a correction right?

Simply put, markets don’t simply die of old age. Ok, it is true that the average length of past bull markets can be calculated (it’s around 55 months), and that they are extremely unlikely to go on forever. And there are risks that are associated with prolonged bull markets, such as interest rate hikes and increased stock valuations. But the problem is that it’s still just too difficult to calculate exactly when a correction will occur, how bad it will be, or how long it will last.

Market cycle lengths vary greatly

In the early 1960s, the bull market lasted 6.4 years before a bear market lasted 1.6 years. From the mid 70s to the late 80s, the bull market lasted 12.9 years, before a 3 month 29.6% correction starting in August 1987. That’s quite a disparity! If you’d like a detailed list of historic bear markets, including lengths and circumstances, further reading is available here.

But this concept is better illustrated with a chart:

Keep in mind that an decrease of 25% (100 to 75) requires an increase of 33.33% (75 to 100) to get back to even. But looking at this, I think there are a couple of big takeaways:

  1. The market repeats the pattern of relatively steady growth, followed by a correction. But historically, we are much more likely to be in a bull market than a bear market. To be fair, some of the ‘bull markets’ in the chart above do include corrections. But the data shows that we have around 2 years of a bull market for every 1 year of a bear market. This makes it even more risky to try to time the market, since on average, we’ll probably be in a bull market.
  2. Because bull and bear markets vary greatly in length, they are very difficult to predict.

But what about other factors, such as rising interest rates, valuations, or oil prices?

Shouldn’t experts be able to make accurate predictions based on certain indicators? You would think, but not so much. Check out this prediction from April 2018 that the bull market was over. Now see a graph of an S&P 500 fund from April 1, 2018 to September 4, 2018.

A simple google search will show dozens of ‘experts’ who agree that now is the time to sell (that’ll be true whether you’re reading this article now or in several years). Here’s a chart from Tony Robbins illustrating this:

On the flip side, at least one analyst believes that the current bull market ‘will last another 15 to 20 years.’ That’s hard to believe, but who knows? And that’s the point: no one does. And the opportunity cost of sitting out is huge. Sitting on the sidelines for 2 or 3 or 4 years or more is extremely costly. Here’s a Bloomberg article hammering home how costly it can be.

“You could say, ‘I don’t care if it’s the 7th or 9th inning of the bull market, I’m getting out,’ ” Andrew Slimmon, senior portfolio manager and managing director at Morgan Stanley Investment Management, said by phone. “But returns in that final leg are really big.”

Psychologically, most people are ‘risk averse’ and experience more pain losing money than pleasure gaining money. But try to remember that in reality, risk goes both ways. Staying out of the market is not really safe, given the risk that you will miss out.

So what are my options?

You have two options. One is to make a lump sum investment into your desired allocation immediately. The other is to dollar-cost average or slowly invest money over time. Based on the above, you may guess my recommendation: invest in a lump sum.

The reason is clear: Based on the past century, we know that the market is much more likely to be in a bull market than a bear market. By holding money in cash and slowly investing over a period of, say, one or two years, you are losing the dividend returns associated with investing, and losing the likely growth that would come with investing.

Now in reality, that’s how most of us have to invest into our 401(k)s and other accounts, but that’s only because we don’t typically have the option of lump sum investing. And while dollar cost averaging works fine, it’s not optimal.

But what if the market crashes right after I invest?

I’m not naive. There’s always a possibility that you get unlucky and the market takes a bad turn right after you invest. My point is that you can’t accurately predict what it’s going to do, and on average, it’s better to invest in a lump sum, so that’s my general recommendation.

To make you feel better, in a worst case scenario, here is a graph of the S&P 500 from September 4, 2007 (just before the housing bubble crash) until September 4, 2018.

The point being that even if you were incredibly unlikely and we entered a correction at the top of the market, right after you invested a lump sum, as long as you don’t panic and sell at the bottom, you will still come out ok in the long run!

Again, if you just can’t stomach investing a large amount due to a potential downturn, then I would suggest using a large portion of the money to pay down debt, which is a sure thing. You may also want to reevaluate your asset allocation and consider something more conservative that will help smooth the bumps of a down market and limit your losses.

Finally, after receiving a windfall, there’s nothing wrong with taking a breath of air before suddenly investing, to make sure that the choice you are making is logical and not based on emotion. This is especially true if it’s a large amount of money.

As always, this is general information for educational purposes, so do your own research before making any important financial decisions.