Are you a better investor than God? Before you answer, read on.
Financial advisers constantly warn against trying to time the stock market. Few people consistently predict the ups and downs.
Many who try end up buying high and selling low, or they get out too early, missing out on more gains. It helps explain why low-fee mutual funds that match a market index like the S&P 500 or Russell 3000 so often post better gains than funds where human beings make the buying decisions.
In a typical year, fewer than 20 percent of fund managers beat the market. Stock pickers can be hot for a year or two, but over the long haul the market wins much more often.
Hence the common advice: Build a balanced portfolio appropriate for your age, goals and risk tolerance, but don’t try to figure out when the market might tank or take off.
Here’s where God comes in.
In a nifty analysis, Nick Maggiulli compared two investment strategies on his Of Dollars and Data blog.
In the first, the imaginary investor “bought the dips,” industry-speak for keeping cash on hand to purchase stock when the market turns down. Every month, he saved $100 and only bought when the market dropped.
Buying the dips, of course, defies the warnings against trying to time the market. But Maggiulli took care of that. He assumed that this investor knew exactly when the market hit bottom between any two all-time highs. In other words, he bought at the lowest price every time. This investor was omniscient; God, if you will.
The second investor employed dollar-cost-averaging, the humdrum approach of buying a fixed amount of stock at regular intervals, no matter whether the market is up or down. A lot of workers use this approach when they regularly contribute to 401(k)s. In this comparison, it was $100 every month.
One rule: Both investors had to keep what they bought. They couldn’t sell off stocks.
Maggiulli then analyzed every 40-year period going back to 1920, adjusting for inflation.
God won, right?
Buy-the-dips underperformed dollar-cost averaging 70 percent of the time. That’s despite the considerable advantage of always buying at the cheapest price. None of us would be so all-knowing.
“Even God couldn’t beat dollar-cost averaging,” Maggiulli wrote.
The analytics manager at Ritholtz Wealth Management in New York goes into detail in his blog about how he performed the analysis. He includes several charts that show how dollar cost averaging wins during several time periods, often not by much, but it still beats the omniscient buy-the-dips investor.
He explained to me that the buy-the-dips strategy works if an investor can perfectly predict the most severe declines. For instance, $100 invested in June 1932 — the low point during the Great Depression — grows to $4,000 by 1972, adjusted for inflation.
But severe dips only come around every couple decades. Plus, few investors have such impeccable timing. Miss the bottom of the dips by just two months and the strategy underperforms dollar cost averaging 97 percent of the time, Maggiulli found.
“It doesn’t work because bear markets are rare, because severe declines are rare,” he told me. “So as you wait around and build up cash to buy the next dip, the market is often rising, leaving you behind.”
Maggiulli conceded that this was more of a thought experiment than reality. Few investors would buy every dip. Most would also sell stocks of companies that they thought were headed for hard times.
Still, many investors day dream about having perfect timing, a voice inside their head that tells them the optimal time to buy. In his limited example, Maggiulli showed that such a voice wouldn’t help. Much of the time, it would be a detriment.
In this case, all-knowing isn’t all that good. Or maybe God favors dollar-cost averaging.
Contact Graham Brink at [email protected] Follow @GrahamBrink.