During times of market volatility, fear can cause would-be investors to run to the sidelines for safety. After all, no one wants to buy an investment today only to see it plummet tomorrow or next week.
So we wait, biding our time for the perfect moment to enter the market. But “timing” the market is much easier said than done. In reality, more investors are burned by market timing than those who succeed with it.
The good news is that you don’t need to time the market well in order to enjoy a strong return. In fact, history has proven that sheer time in the market is a far more important factor.
In this article, we take a deep dive into the historical data to see why “buy-and-hold” investors usually outperform those who try to “buy low and sell high.”
Table of Contents:
Why Time in the Market Is More Important Than Perfect Timing
Here are four reasons why entering the market sooner is more critical to your success as an investor than how the market happens to be faring at the moment you enter.
1. It Allows You to Take Full Advantage of Compound Interest
Compound interest is the process of earning interest today on the interest that you’ve already earned in the past. It’s a powerful force and it can amplify an investor’s investment in incredible ways.
For example, let’s say that you invested $500 per month for 30 years and your investments enjoyed a 7% average annual rate of return. Here’s what your portfolio would be worth in 30 years.
In this example, only $180,500 of your $570,570 portfolio balance would have been due to your contributions. All the rest would have been accrued thanks to compound interest.
And this isn’t an anomalous example. For the vast majority of us, compound interest will be responsible for the lion’s share of our final portfolio balance.
Time is the Key to Maximizing Compound Interest
To illustrate why time is the most important factor when it comes to compound interest returns, consider this example. Two friends have $1,000 to invest in the stock market. Bob invests his $1,000 this year. But his friend, Tom, feels that the market is too unstable and decides to wait. He instead invests his $1,000 at the beginning of Year #2.
Bob’s $1,000 earn a 5% return in Year #1 and a 8% return in Year #2. Tom, on the other hand, waited until the ideal time to invest in the second year and ended up with a return of 10%. With a higher annual return, it would appear that Tom was wise for waiting. But let’s take a look at the math.
In Year #1, Bob would have earned $50, growing his portfolio to $1,050. In Year #2, he would have earned 8% on that $1,050, which is $84. So, at the end of the second year, his portfolio would be worth $1,134.
And Tom? Well a 10% return on $1,000 is $100. So his portfolio at the end of the second year would have been worth $1,100 — $34 less than Bob’s. Bob’s annual return was only “average” compared to Tom’s. But compound interest elevated his average portfolio to make it the winner in this example.
In this example, the difference in investment years was only one year. But imagine if Tom had waited 10 years. The Rule of 72 states that any portfolio that earns an average interest rate of 5% will double its value in about 10 years. So by the time Tom invested his $1,000, Bob’s portfolio would have already been worth $2,000 or more. It’s unlikely Tom would ever be able to catch up.
Best-Day Investments vs. Worst-Day Investments
To further illustrate why market timing is far less important than time in the market, check out the image below which shows the top of a chart from a study conducted by Capital Group.
The chart shows two hypothetical investors who both chose to invest $10,000 per year from 1999 to 2018. The investor on the left managed to invest on the best day every single year during that period. And the investor on the right invested on the absolute worst day every single year.
Would the investor on the right have ended up with the larger portfolio in this extreme hypothetical scenario? Yes. But the more important and surprising fact is that both investors would have more than doubled their principal.
So even the most unlucky investor in the world would have come out well ahead over the past 20 years by choosing to invest rather than keeping his or her money in cash.
Lump-Sum Investing vs. Dollar-Cost Averaging
If you have a lump sum of money to invest, should you invest it all at one time or divide the total investment out over time to spread out your risk? The latter idea is often referred to as dollar-cost averaging and has many proponents.
But many people are surprised to learn math actually favors lump-sum investing. And it’s all because of the concepts surrounding compound interest that we’ve already covered. Over time, the market tends to go up. So the earlier you can get in to take full advantage of compound interest, the better off you’ll typically be.
Vanguard says that immediate investment outperformed dollar-cost averaging over a six-month period in approximately 64% of historical periods. And, over a 36-month interval, lump-sum investing outperformed dollar-cost averaging about 92% of the time.
As Vanguard points out, delaying investment is actually in itself a form of market timing. Dollar-cost averaging can still be a great way to handle your ongoing investments from your monthly income. But if you already have a lump sum of money set aside to invest, the math shows that you’ll typically be better off investing it as soon as possible.
2. It Ensures That You Don’t Miss the Market’s Best Days
The biggest danger of trying to time the market is that no one really knows when the market will hit bottom. And history shows that once it does, it tends to rebound very quickly. In fact, often the majority of the stock market’s annual growth will take place within just a few trading days.
Missing out on the huge gains that happen during the best days of the market can significantly reduce your overall return. The chart below from Schwab Financial Research Center shows how an S&P 500 index investor would have fared from 1950 to 2019.
As you can see, a buy-and-hold strategy would have grown a $1,000 investment to over $192,000. But just missing the market’s 10 best days would have wiped out nearly $100,000 of growth. And missing the top 40 days would have been utterly devastating.
How Time in the Market Affects Risk
All investments come with some risk, but some assets (like equities) are riskier than others (like bonds). You can reduce your risk by increasing the number of bonds in your portfolio (more on that later). But one of the best ways to reduce your risk is to simply give your investments a longer timeframe.
To illustrate this, Betterment has created a tool that shows your probability of a loss or gain by period length. By setting the period length to 6 months, you’ll find that you’d have a 70% probability of enjoying a gain and a 30% probability of taking a loss.
However, if you move the slider to 5 years, you’ll find that your probability of a gain improves to nearly 90%.
And with a 12-year time horizon, your chances of earning a positive return improves to nearly 96%!
How Time in the Market Affects Your Returns
In addition to decreasing your risk, a buy-and-hold strategy also tends to increase your returns. Betterment created a chart that illustrates the median total cumulative return for every given holding period based on the S&P 500 daily total return since 1928. The data shows a clear correlation between longer holding periods and higher returns.
Betterment’s chart makes perfect sense in light of Schwab’s data about the importance of the market’s best days. The data from both brokers make it clear that time is your friend as an investor. Long-term investing reduces your risk and ensures that you will be in the market on its best days.
3. It Allows You to Continue Collecting Dividends
If you plan to take a dividend investing approach, market timing is an even worse idea. Let’s say that you’re considering a stock that you plan to buy 100 shares of Johnson and Johnson, a stock that currently pays a $4.04 annual dividend. In other words, 100 shares of J&J stock would pay you over $400 per year in dividends alone.
By waiting just three years to invest your money, you would have already missed out on over $1,200 in dividends! That’s money that you would have earned regardless of how the stock performed. Even if the stock declined during those 3 years, you would have been paid handsomely to wait for a rebound.
And there’s another reason why dividend investors want to invest as soon as possible. Strong dividend stocks have a reputation for increasing their dividend over time. To use J&J for an example again, they’ve raised their dividend 17 cents since just 2018.
So by waiting to invest in J&J, you’d expose yourself to three risks. First, you’d face the risk of missing out on some of J&J’s best market days. Second, you’d miss out on several dividend payments. And, third, you’d miss out on any dividend increases that may be announced while you’re on the sidelines.
4. It Enables You to Automate Your Investments
The majority of us aren’t professional investors. Therefore, we don’t have the time to research companies in-depth like Warren Buffett or Peter Lynch to decide when to buy or sell them (which is why both of those investing legends are huge proponents of buy-and-hold investing for the average investor).
Most of us are busy enough with our day jobs. So trying to decide when to get in and out of the market often just adds a lot of extra stress. Or it can lead us to make ill-advised emotional decisions based on a random news article that surfaced on our News Feed.
Learn More: The Best Automatic Investment Apps
But with a long-term approach, you can fully automate your investing. And an automated or passive investing strategy can dramatically reduce your anxiety and keep you from panic selling during times of market volatility.
Asset Allocation vs. Market Timing
Automating your investing doesn’t mean that your personal needs and preferences should be ignored. On the contrary, there are many ways to limit your risk or shift your investments over time without resorting to full-on market timing.
Robo-advisors like Wealthfront, Betterment, Wealthsimple, and M1 Finance can create custom portfolios with asset allocations (proportion of equities to bonds) that are based on your risk tolerance. And most of these robo-advisors will rebalance your portfolio automatically to make sure that your asset allocation always matches your preferences.
Many discount stock brokers like TD Ameritrade, Vanguard, and Fidelity also offer target retirement funds. These are mutual funds that start out heavily weighted towards equities. But, as you get closer to your retirement date, the asset allocation mix becomes more conservative to reduce risk.
Focusing on asset allocation, whether through robo-advisor custom portfolios or target date funds, is better than market timing because it’s a systematic approach to investing that takes emotion out of the equation.
Staying on the sidelines can be more damaging to your returns than poor timing. So rather than trying to predict the highs and lows of the market, let time be your ally.
Once you’ve committed to a long-term investing approach, you’ll want to optimize your portfolio in other ways, like using retirement plans to shield your investment income from taxes or reducing your trade investing costs.
Finally, don’t be afraid to ask for help. While robo-advisors and index funds have made DIY investing easier than ever, you might also consider getting professional advice. Paladin is a free service that can match you to vetted financial advisors and it’s done all online. A human financial advisor can help you flesh out a comprehensive financial plan while tailoring advice to your personal situation, needs, and goals.