ONE OF THE biggest benefits the advent of target-date funds has provided to individual investors is the ability to diversify their investments in a simple, cost-effective manner using a single fund. But there is another simple way to diversify your investing that has nothing to do with the investments you choose.
Murphy’s Law states anything that can go wrong will go wrong. Investors often feel this way about the timing of their purchases into the stock market. There’s always a nagging worry that you’ll invest your money right before a huge crash. The beauty of being a long-term investor is that your purchases are spread out over a wide range of market environments.
The majority of normal investors aren’t investing on day one with a huge pool of capital unless they have uber-rich parents or a large inheritance. Instead, you’re investing money periodically out of your salary or making contributions on a set schedule from your bank account, slowly but surely building your wealth.
This is known as pound-cost averaging.
It’s diversifying across time, because sometimes you’re buying when markets are screaming higher, sometimes you’re buying when markets are getting crushed, and sometimes you’re buying when markets are somewhere in-between. If you’re investing consistently like this, it means sometimes you’ll buy more shares with the same amount of money (when markets are falling) and sometimes you’ll buy fewer shares with the same amount of money (when markets are rising).
The most important aspect of pound-cost averaging is that you simply keep buying no matter what.
Trying to get too cute with the timing of your purchases is sure to lead to suboptimal results eventually, because market timing is a game no one can win consistently. This is true even if you try to create a strategy where you only buy when markets are down, which seems counterintuitive to the oldest investment advice in the world – buy low and sell high.
Financial writer Nick Maggiulli performed a study to test this theory by comparing two buying strategies – one simple and one God-like. The first strategy would invest £100 (adjusted for inflation) into the US stock market every month for 40 years. We’ll call this the simple approach to investing. The God-like strategy was completely unrealistic but it assumes you only put that £100 to work at the absolute low point between two all-time highs in the market. So this isn’t just a buy low strategy, but a buy at the bottom of the market in every cycle strategy.
So which approach was the winner?
Shockingly, the simple approach beat God, scoring a 70% win rate going all the way back to the 1920s. And missing the exact bottom of the market in the God-like strategy would take the win rate for that strategy from 30% to just 3%. Plus, no one is good enough to buy at or near the bottom of every bear market. This example shows the tortoise beating the hare even when the hare has Usain Bolt’s speed. Maggiulli concludes, “Even God couldn’t beat pound-cost averaging.”
The reason the simple approach beats God is because investing on a regular basis over the long haul gives your savings more time to grow. Constantly trying to invest at the bottom of the market means sitting on the sidelines and missing out on valuable dividend payments and market appreciation. And since the stock market, over time, goes up more often than it goes down, you could be waiting a long time for a better entry point if you try to time your purchases.
When pound-cost averaging, sometimes you buy higher. Sometimes you buy lower. Sometimes you buy when stocks are undervalued. Sometimes you buy when stocks are overvalued. The only thing that matters is that you keep buying. You’re not beholden to any single point in time.
When viewed from this perspective, volatility in the stock market is no longer your enemy but your friend. It allows you to average in at different price points during different market environments. As a net saver, you should welcome down markets from time to time. Young people with decades ahead of them should say a prayer for falling markets every night before they go to bed.
The only thing that matters is that you keep buying. Fortunately, when you invest part of your salary automatically each month by direct debit, this is already happening.
All of this is especially true when stocks go down – and we can assure you they will.
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