The stock market's drop of nearly 6% to start 2014 did a good job of clearing the air of any investor complacency. Investors haven't faced a U.S. stock market "correction" (defined as a market drop of 10%-20% from the high) since 2011, an unusually long time to go without one.
Add to that the fact that the bull market turns five years old in March — only 5 of the 15 bull markets since the Great Depression have lasted this long — and it wouldn't be surprising if some investors are thinking it might be time to scale back any new investing (or even head for the exits altogether).
Their plan would likely be to return to their normal stock allocation after the next bear market passes. Such timing moves are intended to improve long-term returns, but as we've explained before, that's rarely the result. One reason is that timing isn't as significant a factor as most investors think.
The long-term stock investor prospers because he or she owns shares in businesses that participate in a productive economy. The important thing is not so much when you buy, but that you buy and continue to buy.
The table on the right shows the results of two different approaches. Both Peter and Paul invested $3,000 a year in an S&P 500 index fund, but they did it differently. Peter is the world's best timer: every year he invested his $3,000 on the very lowest day of that year. Paul, on the other hand, simply divided his $3,000 into 12 parts and invested $250 on the last day of every month. The results shown assume dividends were reinvested.
Two facts stand out. First, they were both quite successful. We specifically chose the first two periods to simulate today's fears of investing new money immediately prior to some horrible market breakdown. The first period begins just as the famously difficult 1973-1974 bear market is about to start; the second begins with the infamous "Black Monday" drop of 22.6% only months away. True, Peter earned more — about 1.2% per year in each of these first two scenarios — but Paul also did very well. It turns out you don't need to have Peter's timing skills (thank goodness!) to see your capital grow handsomely in the market over time. The results of the past 30 years are even closer — Peter's impossibly perfect timing skills added only 0.7% annually over this stretch.
This leads to our second observation: being consistent in your investing commitment (which anyone can do) is a much greater contributor to your long-term success than your timing efforts (which very few can do well). While superior timing skills can enhance your returns somewhat, the true engine for capital growth is the steady increase of your ownership stake in American industry month after month. That's why dollar-cost-averaging can be such a powerful tool for the average investor. You don't need to possess great market experience or trading skills to invest successfully; you need only to be tenacious! It takes willpower, not mind power. (See Taking the Guesswork Out of When and How Much to Invest.)
Investors have had a fairly easy emotional ride in stocks the past two years. Eventually, market storms will return — they always do. When that happens, you can expect most investors' emotions will become as volatile as the markets. At that time, it's crucial that you've trained yourself to ask the right question. Not questions like: "What's the market going to do next?" Or, "How low might it go?" No one knows the answers to such questions. Instead, the correct question is: "What does my long-term strategy call for?"
If you've started a dollar-cost-averaging program that calls for you to make monthly investments, then follow through — make your monthly investments as planned. If you have a diversified portfolio in place that reflects the amount of risk suitable for you over the next 5-10 years, then relax and look beyond any potential "valley" experiences in the short-term. The goal is to make "inside-out" decisions, ones based on your personal strategy (which you know) rather than on any speculation as to what the markets may do over the coming 6-12 months (which you will never know).
See Dynamic Asset Allocation: An Investing Strategy for the Risk-Averse for an explanation of Dynamic Asset Allocation, a lower-risk SMI strategy that may offer increased peace of mind in the current market environment.