And why earlier is better than later
BEFORE AMERICAN PHAROAH won the Triple Crown in 2015, no one expected much from the horse. But Jeff Seder felt differently.
Seder had worked as an analyst at Citigroup before quitting and following his passion to predict the outcome of horse races. Seder wasn’t like other equine researchers because he didn’t care about the thing that other horse breeders obsessed over—pedigree.
The traditional view among horse breeders was that a horse’s mother, father, and general lineage were the primary determinant of its racing success. However, after looking through historical records, Seder realized pedigree wasn’t a great predictor. Seder needed to find another predictor and to do that he needed data.
And it was data that he collected. For years Seder measured everything on horses. Nostril size. Excrement weight. Fast-twitch muscle fiber density. And for years he came up empty-handed.
Then, Seder got the idea to measure the size of a horse’s internal organs using a portable ultrasound. Bingo. He hit pay dirt.
Seth Stephens-Davidowitz tells of Seder’s discovery in Everybody Lies:
“He found that the size of the heart, and particularly the size of the left ventricle, was a massive predictor of a horse’s success, the single most important variable.”83
That was it. Heart size was a better predictor of horse racing ability than anything else. And this is what Seder knew when he convinced his buyer to purchase American Pharoah and disregard the other 151 horses at auction. The rest is history.
Seder’s story highlights how deep insight can be gleaned from one useful data point. Hans Rosling echoes this sentiment in Factfulness when he discusses the importance of child mortality in understanding a country’s development:
“Do you know I’m obsessed with the number for the child mortality rate?… Because children are very fragile. There are so many things that can kill them. When only 14 children die out of 1,000 in Malaysia, this means that the other 986 survive. Their parents and their society manage to protect them from all the dangers that could have killed them: germs, starvation, violence and so on.
So this number 14 tells us that most families in Malaysia have enough food, their sewage systems don’t leak into their drinking water, they have good access to primary health care, and mothers can read and write. It doesn’t just tell us about the health of children. It measures the quality of the whole society.”84
Rosling’s use of childhood mortality and Seder’s use of heart size exemplify how complex systems can be more easily understood with a single piece of accurate information.
When it comes to how soon you should invest your money, there is also one piece of information that can guide all of your future decisions.
Most Markets Go Up Most of the Time
The one piece of information that can guide your investing decisions is:
Most stock markets go up most of the time.
This is true despite the chaotic and sometimes destructive course of human history. As Warren Buffett so eloquently stated:
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”85
This logic doesn’t apply solely to U.S. markets either. As I illustrated at the beginning of chapter 11, equity markets across the world have exhibited a long-term positive trend.
Given this empirical evidence, it suggests that you should invest your money as soon as possible.
Why is this?
Because most markets going up most of the time means that every day you end up waiting to invest usually means higher prices you will have to pay in the future. So, instead of waiting for the best time to get invested, you should just take the plunge and invest what you can now.
We can illustrate this with a rather absurd thought experiment.
Imagine you have been gifted $1 million and you want to grow it as much as possible over the next 100 years. However, you can only undertake one of two possible investment strategies. You must either:
1. Invest all your cash now, or
2. Invest 1% of your cash each year for the next 100 years.
Which would you prefer?
If we assume that the assets you are investing in will increase in value over time (otherwise why would you be investing?), then it should be clear that buying now will be better than buying over the course of 100 years. Waiting a century to get invested means buying at ever higher prices while your uninvested cash also loses value to inflation.
We can take this same logic and generalize it downward to periods much smaller than 100 years. Because if you wouldn’t wait 100 years to get invested, then you shouldn’t wait 100 months or 100 weeks either.
It’s as the old saying goes:
“The best time to start was yesterday. The next best time is today.”
Of course, this never feels like the right decision because you are left wondering whether you could get a better price in the future.
And guess what? That feeling is accurate because it is very likely that a better price will appear at some point in the future. However, the data suggests that the best thing to do is ignore that feeling altogether.
We now turn to look at why better prices in the future are likely, why you should not wait for these better prices, and why you should invest as soon as you can instead. Investing sooner rather than later is the best strategy for U.S. stocks and also for nearly every other asset class out there.
Why Better Prices in the Future are Likely (And Why You Shouldn’t Wait for Them)
If you randomly picked a trading day for the Dow Jones Industrial Average between 1930–2020, there is over a 95% chance that the Dow would close lower on some trading day in the future.
This means that roughly 1 in 20 trading days (one a month) would provide you with an absolute bargain. The other 19 would give you the feeling of buyer’s remorse at some point in the future.
This is why it feels like waiting for a lower price is the right thing to do. Technically, there is a 95% chance that you will be right.
In fact, since 1930 the median amount of time you would have to wait to see a lower price after buying the Dow is only two trading days. However, the average is 31 trading days (1.5 months).
The real problem though is that sometimes a lower price never occurs, or you have to wait a very long time before you see this lower price.
For example, on March 9, 2009 the Dow Jones Industrial Average closed at 6,547. This was the exact bottom during the Great Financial Crisis.
Do you know the last time the Dow closed below 6,547 before then?
April 14, 1997—12 years earlier.
This means that if you bought the Dow on April 15, 1997, you would have needed to wait almost 12 years before you saw a lower price. Having the patience to wait this long for a better price is nearly impossible for any investor.
This is why market timing, though appealing in theory, is difficult in practice.
As a result, the best market timing approach is to invest your money as soon as you can. This isn’t just an opinion of mine either. It is backed by historical data across multiple asset classes and multiple time periods.
Invest Now or Over Time?
Before we get started on the data, let’s define some terms that I will use for the remainder of this chapter:
· Buy Now: The act of investing all of your available money at once. The amount of money being invested is not important, only that the entire amount is invested immediately.
· Average-In: The act of investing all of your available money over time. How you decide to invest these funds over time is up to you. However, the typical approach is equal-sized payments over a specific time period (e.g., one payment a month for 12 months).
Visually, we can see the difference between investing $12,000 through Buy Now vs. Average-In over a period of 12 months.
With Buy Now you invest the $12,000 (all of your funds) in the first month, but with Average-In you only invest $1,000 in the first month with the remaining $11,000 being invested in $1,000 payments over the next 11 months.
If you invested into the S&P 500 using these two approaches across history, you would find that the Average-In strategy generally underperforms Buy Now most of the time.
To be more precise, Average-In underperforms Buy Now by 4% in each rolling 12-month period, on average, and in 76% of all rolling 12-month periods from 1997–2020.
While 4% might not seem like much in a year, this is only on average. If we look at the level of underperformance over time, we would see that it can get far worse.
For example, the next chart illustrates this by plotting the performance premium of the Average-In over Buy Now when investing into the S&P 500 over all rolling 12-month periods since 1997.
Each point on this line represents the difference in return between the Average-In and Buy Now strategies after 12 months. For example, the highest point on this line occurs in August 2008 where the Average-In strategy outperformed the Buy Now strategy by 30% in 1 year.
Why did Buy Now perform so badly relative to Average-In in August 2008?
Because the U.S. stock market crashed shortly after August 2008. More specifically, if you had invested $12,000 in the S&P 500 at the end of August 2008, by the end of August 2009 you would only have $9,810 (including reinvested dividends) for a total loss of 18.25%.
However, if you had followed the Average-In strategy and invested $1,000 a month over this same time period, you would have about $13,500 (or a 12.5% gain) by the end of August 2009.
This is how we get to the 30% performance premium for the Average-In strategy from August 2008 to August 2009.
The real takeaway from this chart isn’t this peak though, but that the line is usually below 0%. Where the line is below 0%, Average-In has underperformed Buy Now, and where it is above 0%, Average-In has outperformed Buy Now.
As you can see, most of the time, Average-In underperforms Buy Now. This isn’t just recency bias either. If we were to look at U.S. stock returns going back to 1920, we would find that Average-In underperforms Buy Now by 4.5% in each rolling 12-month period, on average, and in 68% of all rolling 12-month periods. The following chart illustrates this longer period in the same way as the previous chart.
The only times when Average-In outperforms Buy Now are at the peaks before major market crashes (e.g., 1929, 2008, etc.). This is true because Average-In buys into a falling market, and, thus, buys at a lower average price than Buy Now would with a single investment.
And while it can feel like we are always on the cusp of a market crash, the truth is that major crashes have been quite rare. This is why Average-In has underperformed Buy Now throughout most of history.
As we have seen above, Buy Now is better than Average-In when investing in stocks, but what about other assets?
What About Assets Other Than U.S. Stocks?
Rather than filling this book with endless charts illustrating the superiority of Buy Now over Average-In for various asset classes, I have created a summary table instead. The table shows how much the Average-In strategy has underperformed Buy Now over all 12-month periods from 1997–2020.
|
Asset (1997–2020) |
Average-In Underperformance Over 12 Months |
Percentage of 12-Month Periods Where Average-In Underperforms |
|
Bitcoin (2014–2020) |
96% |
67% |
|
U.S. Treasury Index |
2% |
82% |
|
Gold |
4% |
63% |
|
Developed Market Stocks |
3% |
62% |
|
Emerging Market Stocks |
5% |
60% |
|
60/40 U.S. Stock/Bond Portfolio |
3% |
82% |
|
S&P 500 Total Return |
4% |
76% |
|
U.S. Stocks (1920-2020) |
4% |
68% |
For example, the table shows us that for an investor Averaging-In to gold in any 12-month period from 1997 to 2020, the average underperformance against Buy Now was 4%, with Average-In underperforming Buy Now 63% of the time.
As you can see, Average-In underperformed Buy Now by 2%-4%, on average, over 12 months for most assets and in 60%–80% of all starting months.
This implies that if you picked a random month to start averaging into an asset, you are very likely to underperform a similar one-time investment into that same asset.
What About Risk?
We have only compared performance between the Buy Now and Average-In strategies thus far, but we know that investors also care about the difference in risk between two strategies.
Isn’t it riskier to Buy Now than to Average-In? The answer is a resounding “Yes!”
As the next chart illustrates, the standard deviation of the Buy Now strategy is always higher than the Average-In strategy when investing in the S&P 500. As a reminder, the standard deviation shows how much a particular data series deviates from its average outcome. Therefore, a higher standard deviation usually corresponds with a riskier investment or investment strategy.
It is true that Buy Now is riskier because Buy Now invests right away and gets full exposure to the underlying asset straightaway, while Average-In is partially in cash throughout the buying period. We know that stocks are a riskier asset than cash, so it follows that the more exposure you have to stocks, the higher the risk.
However, if you are worried about risk, then maybe you should consider following the Buy Now strategy and investing into a more conservative portfolio instead.
For example, if originally you were going to Average-In to a 100% U.S. stock portfolio, you could follow the Buy Now strategy into a 60/40 U.S. stock/bond portfolio to have slightly better returns for the same level of risk.
As the next chart illustrates, Averaging-In to a 100% U.S. stock portfolio has underperformed Buy Now into a 60/40 U.S. stock bond portfolio most of the time since 1997.
Yes, the underperformance of Average-In is small in this case, but you are getting the small outperformance of Buy Now for the same (or lower) level of risk most of the time. This is what investors want: outperformance, with lower risk. The following chart illustrates the rolling standard deviation of returns for these two strategies over this time period.
As you can see, most of the time the Buy Now strategy into a 60/40 portfolio has the same or a lower level of risk than Averaging-In to the S&P 500 (100% stocks).
In summary, the Buy Now strategy with a balanced 60/40 portfolio usually beats the Average-In strategy for a portfolio of 100% stocks.
So if you are worried about the risk associated with using the Buy Now strategy to go all-in to a portfolio of stocks, there is a better way. Rather than compromising by Averaging-In to a portfolio of 100% stocks, you should consider using the Buy Now strategy to invest in a less risky portfolio, such as 60% stocks and 40% bonds.
Does Investing Your Side Cash in Treasury Bills Make a Difference?
One of the common criticisms of this analysis is that the Average-In method assumes that all of your money sits in cash while you wait to get allocated. Some have argued that this side cash should be invested in U.S. Treasury bills earning a return while you Average-In.
I agree with this logic in theory, but the problem is that most investors don’t follow this advice in practice. Few investors move their money into Treasury bills while they slowly move their money into stocks.
I know this anecdotally because I’ve spoken with financial advisors who have told me so. They have had countless conversations where prospective clients had been in cash for years waiting on the right time to get into the market.
But I also know this from the monthly asset allocation survey conducted by the American Association of Individual Investors (AAII). The AAII survey shows that, since 1989, the average individual investor has had over 20% of their portfolio allocated in cash.86
Even though the premise doesn’t work because investors don’t do this in practice, I’ve examined the data anyway. The next table shows the average underperformance of Average-In compared to Buy Now when you invest your side cash in Treasury bills while Averaging-In to the market.
|
Asset (1997–2020) |
Average-In Underperformance Over 12 Months |
Percentage of 12-Month Periods Where Average-In Underperforms |
|
Bitcoin (2014–2020) |
96% |
65% |
|
U.S. Treasury Index |
1% |
72% |
|
Gold |
3% |
60% |
|
Developed Market Stocks |
2% |
60% |
|
Emerging Market Stocks |
4% |
57% |
|
60/40 U.S. Stock/Bond Portfolio |
2% |
77% |
|
S&P 500 Total Return |
3% |
74% |
For example, the table shows us that for an investor Averaging-In to Bitcoin in any 12-month period from 1997 to 2020, while also holding their cash in Treasury bills, the average underperformance against Buy Now was 96% and this strategy of Averaging-In underperformed Buy Now 65% of the time.
The primary difference from our earlier results is that instead of Average-In underperforming by 2%–4% on average, it now only underperforms by about 1%–3% on average and only in 60%–70% of starting months (instead of 70%–80% of starting months). While there has been a reduction in the size of Average-In’s underperformance, it still exists even if you invest your side cash into Treasury bills.
Do Valuations Matter?
A common response I hear when recommending Buy Now over Average-In is, “In normal times this makes sense, but not at these extreme valuations!”
So, when valuations are elevated across the market, does this imply we should reconsider the Average-In strategy?
Not really.
For the uninitiated, the valuation ratio I am using is called the cyclically-adjusted price-to-earnings ratio (CAPE). CAPE is a measure of how much you would have to pay to own $1 worth of earnings across U.S. stocks. So a CAPE of 10 implies that you need to pay $10 for $1 of earnings. When the CAPE ratio is higher, stocks are more expensive, and when it is lower they are considered cheaper.
If we break down the performance of Average-In versus Buy Now by the CAPE Percentiles since 1960 we can see that Average-In underperforms Buy Now under all of them.
|
CAPE Percentiles |
Average-In Underperformance Over 12 Months |
Percentage of 12-Month Periods Where Average-In Underperforms |
|
CAPE <15 (<25th percentile) |
5% |
67% |
|
CAPE 15-20 (25–50th percentile) |
4% |
68% |
|
CAPE 20-25 (50–75th percentile) |
3% |
71% |
|
CAPE >25 (>75th percentile) |
2% |
70% |
The size of Average-In’s underperformance does decrease as CAPE increases, but, unfortunately, as we try to analyze the periods with the highest valuations, we run into sample size problems.
For example, if we only consider when CAPE was greater than 30 (about the level it was at the end of 2019), Average-In outperformed Buy Now by 1.2% on average over the next 12 months. However, the only time when CAPE exceeded 30 prior to the last decade was the DotCom Bubble!
But if you wait to invest because the CAPE ratio is too high, you could miss out on some big gains. For example, CAPE most recently passed 30 in July 2017. If you had moved to cash then, you would have missed a 65% increase in the S&P 500 by the end of 2020 (including dividends).
If you think that the market is overvalued and due for a major pullback, you may need to wait years, if ever, before you are vindicated. Consider this before you use valuation as an excuse to stay in cash.
Final Summary
When deciding between investing all your money now or over time, it is almost always better to invest it now. This is true across all asset classes, time periods, and nearly all valuation regimes. Generally, the longer you wait to deploy your capital, the worse off you will be.
I say generally because the only time when you are better off by averaging-in over time is while the market is crashing. However, it is precisely when the market is crashing that you will be the least enthusiastic to invest.
It is difficult to fight off these emotions, which is why many investors won’t be able to keep buying as the market falls anyways.
If you are still worried about investing a large sum of money right now, the problem may be that you’re considering a portfolio that is too risky for your liking. What’s the solution to this? Invest your money now into a more conservative portfolio than you normally would.
If your target allocation is a 80/20 stock/bond portfolio, you might want to consider investing it all into a 60/40 stock/bond portfolio and transitioning it over time. For example, you could invest your portfolio into a 60/40 today with a specific plan to rebalance to a 70/30 a year from now and then to an 80/20 a year after that.
This way you still earn some return on your money without taking as much risk initially.
Now that we have discussed why getting invested now is better than waiting, let’s tackle why you should never wait to buy the dip.
83 Stephens-Davidowitz, Seth, Everybody Lies: Big Data, New Data, and What the Internet Can Tell Us About Who We Really Are (New York, NY: HarperCollins, 2017).
84 Rosling, Hans, Factfulness (Paris: Flammarion, 2019).
85 Buffett, Warren E., “Buy American. I Am,” The New York Times (October 16, 2008).
86 “Asset Allocation Survey,” aaii.com (March 13, 2021).