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Frequently Asked Questions (FAQs)

Q: Why don't you incorporate market timing into your strategies? Is dollar-cost averaging a good idea?

A: Market timing sounds great in theory, but in practice it not only fails to improve investment performance, it usually reduces investment performance (more on that later).

The idea of market timing is to remove an investment from a financial market when the market is near the "top." Then wait until the market is at the "bottom" and move the money back into the market. Continue the process over and over, buying low and selling high (all the while paying trading commissions and generating negative tax consequences). If an investor can time the market correctly and consistently over time, that investor can make a lot of money.

In reality, it is deceptively difficult to know when a market is near its top. When the market nears a top, investment outlooks are rosy, investors have been making a killing, company profits are rolling in and the bookshelves of your local bookstore are chock full of "get rich quick" books featuring the latest investment fad (in 2000, it was tech stocks, in the mid-2000's it was real estate and housing stocks, etc.). And occasionally you will read an article buried in the back of a financial publication about how some investment guru has been calling for a bear market for the last three years. You are thinking, "I'm glad I'm not that guy...he's missed a great bull market."

But right about that time, the market heads downward on one of its natural cycles and the guru who has been calling for a bear market tells the press, "See? I told you!" but neglects to tell you about all the great gains he has missed by being out of the market.

On the flip side, it's also deceptively difficult to know when a market is near its bottom. Investment outlooks are gloomy, articles start popping up about how gold is the the safest investment (even though it historically has a return approximately equal to inflation and is extremely volatile), and everyone thinks the economy will get much worse. And your local bookstore's shelves are full of books touting "How To Profit From the Coming Catastrophe."

The facts: studies show that when people attempt to time the market with real investments, not only are they usually wrong, they usually end up getting it exactly wrong: putting more money into the markets at the "top" (due to greed) and selling at the "bottom" (due to fear).

To illustrate the point, here is a recent article we wrote:

Market Timing Usually Leads To Disaster

Want to boost your portfolio's long-term profits by 41%? Then don't try to time the market. That is the conclusion reached by DALBAR Inc., a mutual fund research company. The firm compared two scenarios over the last twenty years:

  • one investor systematically invests an equal amount into the stock market each month (also known as dollar-cost averaging)
  • the other investor invests the same amount, but the timing of the investments are made mirroring the actual pattern of the average investor during the twenty-year period

The end result? The investor who ignored the ups and downs of the financial markets and consistently invested a fixed amount into the stock market each month had investment profits 41% higher than the investor who tried to guess when the market was going to go up or down.

Why such a big difference? DALBAR states that, "Investors are motivated by greed and fear Ė not by sound investment practices. Close examination of investor behavior reveals that as markets rise, investors pour cash into mutual funds, and a selling frenzy begins after a decline. Tracking the dollars going into and out of mutual funds over a given month compared to market performance proves the correlation: as markets rise, cash flows swell; as markets decline, cash flows deflate."

Research by Russell Investments also found that investors poured money into the stock market near market tops and withdrew money near market bottoms. February of 2000 saw the largest-ever net inflows of money into stock mutual funds. The very next month the stock market reached its peak which was the start of one of the worst declines in history. With perfectly awful timing, investors had once again incorrectly guessed the direction of the market.

The same bear market bottomed out in October 2002. Some of the largest outflows from the stock market occurred in the few months preceding October, meaning many investors were once again timing the market in the very worst way.

The next time fear or greed grips you when investing, think twice about giving into your emotions when it comes to trying to time the market. The odds are you will do much better consistently adding to your investments regardless of the market outlook.

DALBAR's study concludes with some wise words for investors, "Start early, keep contributing and donít panic."

 

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