Markets & Research
There’s no doubt that this is a supremely trying time for investors. Equities have been dragged down by fear that the coronavirus will inflict deep economic damage. Even some areas of the bond market were clipped by a dramatic flight to cash. It’s understandable if you feel apprehensive, given that a bear market is underway and a recession seems all but certain.
At moments like this, there’s a natural instinct to want to hit the pause button — to either reduce stock exposure or delay putting in additional money before the coast is clear. That sure sounds appealing in theory. Unfortunately, market timing carries significant risk. History has shown that it’s impossible to time market movements with any degree of accuracy and that retreating to the sidelines can hinder long-term investment results because you are statistically more likely to miss out on gains when they come.
We believe in building a long-term asset allocation based on your time horizon, risk tolerance, risk capacity and financial objectives. Having an appropriate asset allocation can help you get through a crisis period without needing to sell long-term investments that suffered short-term declines.
Exiting the market at just the wrong time can be costly, especially considering that a rebound from the bottom can come in short, concentrated bursts. This suggests that investors may be best served by staying the course through short-term fluctuations.
Being on the sidelines during spurts of strength is no better. If you are out of the market, you’re unable to benefit when conditions improve and you’re forfeiting prime opportunities while prices are down.
So what can you do to avoid the feeling of missing out? A proven method is dollar-cost averaging (DCA), which involves making regular investments over time. By easing into the market over a longer time frame, you have the opportunity to smooth out the effects of volatility. It’s far preferable to jumping out of the stock market during turbulence and crossing your fingers that you will be able to get back in at precisely the right point.
To assess the merits of dollar-cost averaging, we examined a range of economic environments in the postwar period, beginning in 1946. Not surprisingly, DCA trailed a lump-sum approach in rising markets. However, if reducing risk is a primary objective, DCA can be prudent. It’s also a fine way to build conviction during times of maximum stress, allowing investors to solidify a position without the anxiety that can come from making a single large investment.
To illustrate, we assembled a graph that shows how a variety of DCA approaches stacked up against lump-sum investing. In rising markets, DCA rarely outpaced lump-sum investing. But in falling markets, it often mitigated losses, and it did this better when stretched out over longer periods. Importantly, it takes fortitude to make investments when markets are declining, but using DCA at such times allows you to purchase more shares at a lower average cost. And during a potential market rise, those extra shares could enhance your portfolio’s value.
Of course, most of us invest for longer than a year. So we extended our analysis and found that the next four years were a much larger factor than the initial 12 months, regardless of whether that first year was positive or negative. That’s a reminder that long-term wealth accumulation goals are a critical part of any investment regimen. DCA can help investors confidently position themselves.
It might be tempting to believe that economic indicators can help you divine the perfect moment to invest. But gauging the direction of the market based on specific indicators is extremely difficult.
Studying how events correlated to market performance, Capital Group analysts found that equity markets grew during most 12-month periods, even when economic indicators were negative. Surprisingly, high inflation, surging gold prices and elevated unemployment didn’t predict market downturns. In fact, stocks appreciated in 79% of all rolling 12-month periods. Recessions were the only factor that seemed related to a limp stock market, but even then stocks gained 53% of the time.
We also looked at whether weak markets could predict strong markets. Over the same postwar time frame, we found that markets fell by 10% or more in one-tenth of 12-month periods. In the year after such a downturn, we found that another fall of 10% or more happened about one-quarter of the time and a gain of 20% or more happened about half the time. In other words, the best prediction for specific market movements isn’t much better than a hunch.
The lesson: Betting on a specific market movement is a bad strategy, but in general the markets have gone up more often than they’ve gone down.
On March 9, 2009, the bear market that accompanied the global financial crisis ended, ushering in the longest-ever bull run. Of course, no one knew that at the time. For all they knew, it might have been a blip, like when equities showed signs of life the preceding July. But investors who sat on the sidelines, waiting for a perfect signal that the coast was clear, missed those early gains — and missing such days can have long-term consequences.
Consider: $1 invested in the S&P 500 index in 1927 would have grown to $7,030 by the end of 2018, despite the damaging bear markets along the way. That included the Great Depression, the global financial crisis of 2008 and all manner of disruptions in between. Missing the best 40 months — less than 4% of the total time — would have lowered that ending value to a mere $40.48.
Because it’s impossible to know when markets will turn, investors would be well advised to stay the course, even in times of volatility. If investors been waiting for a correction to finally enter the market, DCA can provide a disciplined and cautious approach to attaining their long-term target allocation. By carefully managing how they invest, they can help mitigate the downside that can come with market turbulence.
The above article originally appeared in the Spring 2020 issue of Quarterly Insights magazine.