The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.
—John Bogle, Common Sense on Mutual Funds, Wiley (March 1998)
According to the Oxford English Dictionary, the expression “a fool’s errand” is thought to have originated in the early 1500s. The first recorded use of the phrase is in the play Sir Thomas More by Anthony Munday, which was written in 1592. In the play, one of the characters says, “This is a fool's errand: we are sent to seek a needle in a bottle of hay.” The expression is thought to have originated from the idea that a fool is unable to see the futility of their actions. A fool’s errand is therefore a task that is pointless and unlikely to succeed.
Trying to outperform the market by timing exits (just before the bear awakens from its hibernation) and entries (as the bull enters the arena) is a fool’s errand. For example, my first book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, published in 1998, contains the following tale told by Peter Lynch in a September 1995 article for Worth titled “Fear of Crashing.” Lynch argued that the best way to cope with the fear of a market crash is to assume the worst and examine the results. He explained that if you had invested the same amount on January 1 of every year for 30 years starting in 1965, your return would have been 11% per annum. On the other hand, if you had been unlucky enough to have invested the same dollar amount on the day the S&P 500 Index hit its peak for the year, your return would have been 10.6%, a difference of less than one-half of 1 percentage point – not only is no one that unlucky, you could not do it if you tried. On the other hand, if you invested on the day the S&P 500 hit its low for the year, your return would have increased to 11.7%, again a difference of not much more than one-half of 1 percentage point.
Lynch’s point was that it is virtually impossible to time the market perfectly, and that trying to do so is not worth the risk.
In the article, “Does Market Timing Work?” the research team at Charles Schwab performed a similar analysis to that done by Lynch, adding a few other strategies and covering longer periods. They considered the performance of five hypothetical long-term investors following five different investment strategies. Each received $2,000 at the beginning of every year for the 20 years ending in 2022 and left the money in the stock market as represented by the S&P 500 Index:
- Peter Perfect invested $2,000 in the market every year at the lowest closing point.
- Ashley Action invested her $2,000 in the market on the first trading day of the year.
- Matthew Monthly dollar-cost averaged (DCA), investing his annual $2,000 allotment into 12 equal portions at the beginning of each month.
- Rosie Rotten invested her $2,000 each year at the market's peak.
- Larry Linger, convinced that lower stock prices were always around the corner, stayed invested in Treasury bills for the entire 20 years.
Surprising results
Unsurprisingly, the best results belonged to Perfect Peter, who accumulated $138,044. But in stunning fashion, Ashley Action came in second with $127,506 – only $10,537 less than Peter Perfect: “This relatively small difference is especially surprising considering that Ashley had simply put her money to work as soon as she received it each year – without any pretense of market timing.” Matthew's DCA approach came in third, accumulating $124,248. It should not be a surprise that DCA underperformed, as in a typical 12-month period “the market has risen 75.4% of the time.” Even Rosie Rotten’s results should prove encouraging. While her poor timing left her $15,214 short of Ashley (who didn't try timing investments), Rosie still earned about three times what she would have if she hadn't invested in the market at all. Also unsurprisingly, Larry Linger fared worst of all, with only $43,948: “While his biggest worry had been investing at a market high, had he done that each year, he would have earned far more over the 20-year period.”
Consistent findings
Schwab then analyzed all 78 rolling 20-year periods dating back to 1926 and found that in 68 of the 78 periods, the rankings were the same. Even in the 10 periods when this was not the case, investing immediately never came in last. It was in second place four times, third place five times and fourth place only once, from 1962 to 1981, one of the few extended periods of persistently weak equity markets. What's more, during that period, fourth, third and second places were virtually tied.
Schwab also looked at all possible 30-, 40- and 50-year time periods starting in 1926. If the few instances weren’t counted when investing immediately swapped places with dollar-cost averaging, all time periods followed the same pattern. In every 30-, 40- and 50-year period, perfect timing was first, followed by investing immediately or dollar-cost averaging, bad timing and, finally, never buying stocks.
Schwab concluded: “Our research shows that the cost of waiting for the perfect moment to invest typically exceeds the benefit of even perfect timing. And because timing the market perfectly is nearly impossible, the best strategy for most of us is not to try to market-time at all. Instead, make a plan and invest as soon as possible.”
Investor takeaways
The expression “a fool's errand” is a reminder that it is important to think carefully before embarking on any task. If a task seems too difficult or unlikely to succeed, it is probably best to avoid it. Thus, if you make an annual investment (such as a contribution to an IRA or a 529 plan) and you're not sure whether you should invest in January of each year, wait for a “better” time, or dribble your investment out evenly over the year, the evidence clearly demonstrates that investing immediately puts the odds in your favor. And that’s the best we can do given the uncertainty of investing. As Charles Ellis, author of Winning the Loser’s Game, noted, “Market timing is unappealing to long-term investors. As in hunting deer or fishing for rainbow trout, investors have learned the importance of ‘being there’ and using patient persistence – so they are there when opportunity knocks.”
The other takeaway is that it is critical to determine how much exposure to the risks of equities is appropriate given your ability, willingness and need to take risk. Limiting the risk exposure will help provide the discipline necessary to enable you to endure the stress that bear markets cause without engaging in panic selling.
With that said, there is one more point I need to discuss about the DCA approach.
Dollar-cost averaging
A popular myth is that the best way to address the volatility of the stock market is to invest equal amounts on a regularly scheduled basis – dollar-cost average over a predetermined time (such as on the first of each month for one year). Like much conventional wisdom, it is based on a common-sense idea: In an unpredictable and highly volatile world, you will be buying at both high and low prices.
The issue of DCA typically arises when an investor has received a large lump sum of money. They wonder if they should invest it all at once or spread out the investment over time. The same problem arises when an investor has panicked and sold when confronted with a bear market, but then there are two questions: How does the investor decide when it is safe to reenter the market? And does she reinvest all at once or by DCA?
From an academic perspective, the answer to the question of which is the winning strategy, lump sum investing or DCA, has been known for a long time. The June 1979 issue of the Journal of Financial and Quantitative Analysis published an article by University of Chicago Professor George Constantinides, “A Note On The Suboptimality Of Dollar-Cost Averaging as an Investment Policy.” Constantinides demonstrated that DCA is an inferior strategy to lump-sum investing. This was followed in 1992 by a paper by John Knight and Lewis Mandell, “Nobody Gains From Dollar Cost Averaging: Analytical, Numerical and Empirical Results.”
Knight and Mandell compared DCA to a buy-and-hold strategy and then analyzed both across a series of investor profiles from risk averse to aggressive. The authors stated: “Brokerage firms endorse DCA for two reasons. First, they state that returns are increased because more shares are purchased when prices are low and fewer when prices are high. Secondly, they assert that DCA enhances investor utility by preventing an ill-timed lump sum investment. Our results do not support either of these contentions.” They concluded: “Using three separate methods of comparison, we have shown the lack of any advantage of DCA relative to two alternative investment strategies. Our numerical trial and empirical evidence, in consonance with our graphical analysis, both favor optimal rebalancing and buy and hold strategies over dollar cost averaging.”
The 2011 paper by the firm Gerstein Fisher, “Does Dollar Cost Averaging Make Sense For Investors?,” took another look at the subject. The authors began by asking: “When will the DCA strategy not work? It won’t work when, in general, prices rise. Since markets are moving up, every time more cash is invested, it is being invested at a higher cost. On the flip side, this strategy will work over the long run if markets are moving downward – every new purchase is made at a lower cost than the previous one.” So, which is more likely? The S&P produced positive returns in over 60% of the months between January 1926 through December 2010 and in over 70% of the years between 1926 and 2010. Thus, the answer should be obvious.
The authors then set up the following test. To compare the performance of DCA versus lump-sum investing (LSI), the two strategies were backtested between 1926 and 2010. Transactions costs were ignored (favoring DCA, which involves more trading). The initial portfolio was assumed to be $1 million in cash, and the only investment available was the S&P 500 Index:
- DCA strategy: One-twelfth of the initial portfolio was invested each month at the beginning of the month – the entire $1million was invested by the beginning of the 12th month.
- Lump sum strategy: The entire $1 million portfolio was invested on day one.
The study covered 781 rolling 20-year periods. The LSI strategy outperformed in 552 of them – over 70% of the time. In addition, in the roughly 30% of instances in which DCA outperformed, the magnitude of that outperformance was less than when LSI outperformed. Specifically, during the 552 20-year periods in which LSI did better than DCA, the average cumulative outperformance was $940,301 on the initial $1 million investment. During the 229 periods in which DCA did better than LSI, the average cumulative outperformance was $769,311.
The authors even looked at how the two strategies performed during the 10-year period 2001-2010. For the 109 rolling 12-month periods, LSI outperformed in 70 (64%). The average outperformance was 1.3 percentage points.
And then there is the evidence from the Charles Schwab study. Unfortunately, despite all the evidence, some investors and advisors still recommend DCA. They are either unaware of the evidence or the simple logic: Since there is always an equity risk premium (stocks have higher expected returns than bonds), common sense tells us to invest all at once. Unfortunately, many investors and even many financial advisors do not always base decisions on logic or evidence. In fact, emotions often play a far greater role in decision-making than logic.
The Lesser of two evils
Despite the evidence and logic presented, there is one exception to the rule of avoiding DCA. An argument can be made in its favor when it is the lesser of two evils – when an investor simply cannot “take the plunge” because they are sure that if they invest all at one time, that day would be the high not exceeded until the next millennium. That fear causes paralysis. If the market rises after they delay, how can they buy now at even higher prices? And if the market falls, how can they buy now because the bear market they feared has arrived? Once a decision has been made to not buy, exactly how do you make the decision to buy?
There is a solution to this dilemma, one that addresses both the logic and the emotional issues. An investor should write a business plan for her lump sum. The plan should lay out a schedule with regularly planned investments. The plan might look like one of these alternatives:
- Invest one third of the investment immediately and invest the remainder one-third at a time during the next two months or next two quarters.
- Invest one quarter today and invest the remainder spread equally over the next three quarters.
- Invest one sixth each month for six months or every other month.
Once an investor has written the schedule, she should sign the document. If the investor has an advisor, she should instruct them to implement the plan regardless of how the market performs. Otherwise, she might be tempted by the latest headlines or guru forecasts.
Having accomplished those objectives, the investor should adopt a “glass half full” perspective. If the market rises after the initial investment, she can feel good about how her portfolio has performed and how smart she was to not delay investing. If, on the other hand, the market has fallen, she can feel good about the opportunity she now has to buy at lower prices and having been smart enough to not have put all her money in at one time. Either way, she wins from a psychological perspective because we know that emotions play an important role in how individuals view outcomes.
Once an investor is convinced that a gradual approach is the correct one, ask the following question: Having made your initial partial investment, do you now want to see the market rise or fall? The logical answer is that you should root for the market to fall so you can make future investments at lower prices.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The examples provided above or for illustrative purposes and do not reflect an actual client experience. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-574
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