Marcus wrote in with a great reader mailbag question that really couldn’t be answered in brief, so I expanded my answer into a post. Here’s what Marcus had to say:
There seems to be a consensus right now that the stock market is near a high point and is going to drop in the future and yet you suggest not selling stocks right now. Why not? Aren’t you supposed to buy low and sell high?
The stock market has been on an upward trend and has been quite bumpy as of late, with some big one-day drops and some recoveries in between those drops. The reason for that is simple – some people think it’s time to sell and are selling, while others see the drop in prices after the result of that sale and think that it’s time to buy and are thus buying.
In both cases, we’re talking about huge financial institutions that play on the day-to-day changes in the market in order to make money. For a company with, say, $500 billion in managed assets, a 0.1% change in the market means $500 million dollars. There’s a huge amount of money at stake for those people.
However, those people have little to do with what average investors ought to be doing in their day to day lives, for several reasons.
First, for most investors, a small change in the stock market isn’t going to add up to a lot of money. Let’s say you have $100,000 invested in the stock market. A 0.1% change is only $100. That amount of money is not going to make you or break you.
Second, brokerage fees on buying and selling will eat up a lot of whatever you gained. Let’s say you’re with a brokerage that charges you $10 for every “buy” or “sell” you order, and let’s say your stock is split up among 10 different companies. If you choose to sell it all, that’s ten “sell” orders, which at $10 a pop is going to eat up the $100 you might have lost in a 0.1% drop.
A combination of brokerage fees and a low overall balance means that most ordinary people can’t afford to buy and sell very frequently in a normal investment account. If you buy and sell very much at all, your gains are going to be completely devoured and any losses are going to be amplified. It is a losing game, period.
The large investors get around this because large investors avoid those brokerage fees — they actually have people on the floor of the stock exchange. A brokerage fee essentially means that you’re paying for someone who has a seat on the floor of the stock exchange to execute that trade for you. Those big investors don’t have to worry about those fees for each trade – they’ve already got their people on the floor and those people are usually salaried, so they can buy and sell as they wish.
In other words, in a normal, taxable account, unless you have all of your money tied up in just one or two investments and are extremely skilled at guessing the peak of the market, you’re not going to make money by timing the market.
Now, has the peak already passed? Or is it yet to come? Will the stock market be higher than it is now in five years? You can’t answer those questions and neither can I. No one can.
A much better approach is to let the money sit in the investment until you need it, letting it ride the ups and downs of the market.
Why Buying and Selling Doesn’t Work: An Example
Let me give you a very specific example, with numbers from the past several years. I’m going to use points that are near but not exactly at market highs and lows for this example, because no one is going to be able to accurately nail the highs and lows.
Let’s say someone had $10,000 to invest on January 1, 1998. You decide it’s a great time to invest – this is the period of “irrational exuberance,” right? You buy into an S&P index fund, which sits at 963.36 per share. So you wind up with 10.37 shares (remember, there’s a $10 brokerage fee, so you’re only actually buying with $9,990). We’re going to assume for convenience sake that each year you’re in the stock market, you’ll earn $200 in dividends, to keep it easy.
Okay, you stay in until January 1, 2002, earning $800 in dividends along the way, where the stock market has now spooked you. It’s going to go down – way down, you think. It’s already off of the record highs it set earlier, so now it’s at 1,140.21. You sell your 10.37 shares and pay the $10 brokerage fee. This leaves you with $11,813.98.
You sit on that until January 1, 2005, where you’ve now read the tea leaves and you believe the stock market is going to shoot up in the coming years. You watched it bottom out in 2002, struggle to come back to life, and then start chugging along in 2004, so you believe the bad part is over. You buy back in with your $11,813.98, and the S&P 500 is at 1181.41, so you’re able to buy 9.99 shares in the S&P 500 after your $10 brokerage fee.
You sit on that until January 1, 2009, where you’ve witnessed a huge downturn in the market and you want out. You earned $800 in dividends over the last four years. You decide to sell your 9.99 shares, but the S&P 500 is at 865.58, so you earn $8,637.14 on the sale. You sit out for a year.
On January 1, 2010, you decide to buy back in because the bad times are over. The S&P 500 is at 1,123.58, so your $8,637.14 buys you 7.68 shares in the S&P 500. You just sit on that up until August 21, 2015, earning $1,200 in dividends (I’ll count the full year for 2015 there). The S&P 500 is at 1,970.97, meaning your investment is worth $15,137.04. You also made $2,800 in dividends along the way on your initial $10,000, so that $10,000 turned into $17,937.04. Good, right?
Now, what happens if you just buy in on January 1, 1998 and just leave it there? You buy 10.37 shares on that date. Then, over each of the next 18 years, you earn $200 in dividends, totaling $3,600 in dividends. Your 10.37 shares are now worth $1,970.97 apiece, so your investment is worth $20,438.96. Your $10,000 turned into $24,038.96.
In other words, if you just sat there and didn’t even look at your investment for 18 years, you made way more money than someone trying to time the market. It’s not even close.
Why? Well, for one, the person timing the market is never going to hit the exact bottom or the exact top. Often, the beginnings of a stock market turnaround in either direction look like normal volatility. It isn’t until a big slide or a big jump is in full effect that it becomes clear. Because of that, you’re not actually buying at the low or selling at the high.
If you do try to perfect your guesses, you’re going to just end up buying and selling a lot more often. You’ll probably eventually hit the exact top and the exact bottom, but you’ll be doing a lot of poor buys and sells near those dates and each of those actions will cost you brokerage fees. It’s not going to work out for you, in other words.
That leads us into the second problem – the brokerage fees. Here, the brokerage fees ended up costing about 0.01 shares on each trade, shaved off the top. Each time you bought, you ended up paying a brokerage fee, which meant you got a little less in terms of shares than what you paid for. Each time you sold, you paid a brokerage fee, which meant you got $10 less back than you paid for.
Another problem is that whenever you’re not in the market, you miss out on dividends. Even if stocks are dropping, the companies still pay out dividends at around, say, 2% per year, which means that if you look straight at the current sticker value of the S&P 500, you’re missing out on the money you’ll make by just sitting around and earning dividends.
Yet another problem with buying and selling is that if you do it too often, the gains you earn won’t be long-term capital gains. When you sell stocks, you want anything you gain to be a long-term capital gain so that you pay a lower rate in taxes.
What about retirement accounts? The only thing a retirement account helps with is the tax issue. When you sell within a retirement account, it doesn’t matter in terms of taxes – all that matters is what comes out of the accounts when you actually make withdrawals in retirement.
Having said that, everything else above remains true with retirement accounts – you’re still facing brokerage fees, missing out on dividends, and being inaccurate about hitting the tops and bottoms of the market.
That’s the problem with trying to hit the market. As you do it, you’re facing brokerage fees which cost you on every single buy or sell, you miss out on dividends while you’re out of the market, you’re not perfectly accurate as to the tops and bottoms of the market, and you’re probably not doing much good with your money when it’s not in the stock market. Those add up to a fool’s game, in my opinion, for the casual investor (meaning me and you) when trying to time the market when buying and selling stocks.
What You Should Do Instead
So, what’s the alternative strategy here?
My strategy is simple. I only invest in the stock market if I have a long-term goal, meaning more than 10 years down the road from when I put the money in. I invest that money in index funds and then sit on them until I need to sell them off. I don’t care what the market does today or tomorrow or next month. It can go up 20% or down 40% – I’ll just ride it out until I actually need the money.
So, let’s break this down into bits.
Why only long-term investing? As I pointed out in the above example, the stock market is very volatile. Note that “volatile” is the word I chose, not “risky” or anything else. Volatile simply means that over the course of a day or even a year or two, the behavior of the stock market can be really erratic. It can go way up or way down over that short period in time based on all kinds of human behaviors – short-term panic, short-term exuberance, and so on.
However, over the longer period, cooler heads prevail and things settle down. What happens over time is that stocks have always and, for the foreseeable future, will always go up over the long term – and by long term I mean more than a decade at least. Stocks will retain value because the companies that issue them pay out dividends, which means that if nothing else, you can just sit on them and earn some income without doing anything else. Stocks will grow in value because companies that are healthy usually slowly increase their dividends over time as the value of that company grows. A healthy company grows in value because, over time, there is a constant growth in good ideas and worker productivity all over the world.
So, in the end, as long as there is a constant growth in good ideas and worker productivity and economies remain generally stable, the stock market is a good long-term investment. I view such investments as more of an investment in capitalism than anything else.
Why index funds? One of the challenges of investing in the stock market is knowing what to invest in, however. The stock market is made up of the stocks of a lot of different companies, some good, some bad. Some big companies might shrivel over the years, while others grow up. It’s hard for individual investors to gauge which companies are going to remain healthy over the course of a long-term investment.
Remember, for example, that a decade ago, Facebook was nonexistent and Apple and Google were comparatively tiny, just to name three companies. On the other hand, it only took a couple of years for Enron, which was one of the biggest companies in the country, to go from enormous to completely out of business.
Index funds solve that exact problem. Index funds essentially allow you to buy a sliver of the stocks of a lot of companies at once. Some simply include a bit of every publicly traded stock in the United States.
What does that mean? It means that some companies will boom – and you’ll be on board for every one of them. A few will go bust, and you’ll ride that elevator, too. Many others will be strong and stable and grow steadily over the long haul, and you’ll ride those as well.
Not only that, index funds are very, very cheap. They often have minimal fees to buy them, especially if you shop around, and they usually come with very minimal management fees, too.
All of our investment money is in index funds for those reasons.
Why “buy and hold”? It should be pretty clear from the above example why I prefer to buy and hold an investment rather than buying and selling and buying and selling an investment.
Buying and holding means that you’re not paying brokerage fees on all those transactions. Buying and holding means that you never miss out on even a little bit of a stock market upswing. It also means that you really don’t have to worry about your investments on a daily basis – they’re just fine without your active interference.
Each week, I stick some money into our investments. All of that money is just going to sit there until we need it.
‘But the Bumpy Stock Market Is Scary!?’
The biggest reason people are tempted to sell when the stock market dips is because, frankly, it’s scary. It’s hard to see the stock market have a few hard days and you see 10% of your investments just vanish in a week. Over the course of a few months in 2008, people saw 40% of their investments vanish. That’s really, really hard for some people to swallow.
The problem with that perspective is that it just ignores why you’re invested in the stock market in the first place.
First of all, you should only invest in the stock market if you have a long-term goal. If you don’t know what your goal is, don’t put money in the stock market. It’s a bad place to put money that you may want in a year or even in five years. Don’t.
Once you do that, your money is on a journey not too different than driving along a curvy country road. That road is going to get you to your destination, but it’s going to curve on the journey. Sometimes, that road is going to curve in a direction you don’t like.
Selling your stock in the midst of a downturn is kind of like stopping your car when the country road curves away from your destination for a little while, or deciding to try to take your car off the road and drive straight in the direction of your destination. Both are really foolish ideas that might feel good in the moment because you’ve exerted some “control,” but in both cases will cause you to actually take longer to get to your destination.
Stay on the road. You know it’s going to curve away from your destination sometimes. You know your investment is going to drop in value. But, at the same time, you know the road is going to curve back toward your destination. You know your investment is going to rebound.
One last thing: The media loves to hype market fluctuations as if they’re big news, but the truth is that they’re ordinary events. Just like the economy goes up and down over time, the stock market does the same thing. It’s all cyclical, it’s all normal. The media reports on this stuff because it’s something to breathlessly talk about, even though it’s as normal as the changing of the seasons. Don’t waste your time listening to their hype and getting yourself all worked up.
I’m going to give you one final secret, the one way to make market timing actually work. It’s a powerful secret, so be careful with this knowledge.
The one way to actually make money with market timing is to use a time machine.
Do you have a time machine? No? Then market timing isn’t worth it.
You can’t guess day to day where the peaks and valleys of the market are, and if you miss it by much, you’re going to cut enormously into any advantage you might get from market timing. Add into that the fact that you’ll be paying brokerage fees and you’re devoting a lot of time to study, and the disadvantage grows.
The much better approach is to do things passively. Only invest in stocks if you have a goal that’s more than a decade in the future. Buy a broad based index fund (like the Vanguard Total Stock Market Fund) and reinvest the dividends. Then ignore it until you actually need the money. The market will go up. The market will go down. It doesn’t matter.
It’s simple and it works. Good luck.