The US stock market, measured by the S&P500 index, has returned over 200% since its 666 “devil’s low” in March 2009. Stocks in most other regions, including the UK, Europe and many emerging markets have done similarly well. Many investors have made a lot of money in the recent years. However, there are also many investors who had sold during the panic of 2008 and didn’t re-enter – in 2015 they are still in cash, waiting for the next correction and missing the rally entirely.
It would be very hard to find a single person who had stayed out of the market throughout its fall in 2007-2009, got in exactly (or almost exactly) at the March 2009 low and stayed invested the whole time since then, resisting the urge to sell on the numerous corrections which some analysts always considered the beginning of the next big crash. In other words, it’s hard to find a person who can enter and exit the market with perfect timing.
Indeed, it is hard to find people whose market timing abilities are good enough to at least make more money than simply staying invested the whole time and doing nothing, especially when transaction costs are taken into consideration. You can compare the returns of actively managed funds with those of passive or index funds for quick evidence – majority of the actively managed funds are lagging behind. Although there are always fund managers who get it right on a few occasions and outperform for a few years, such record is rarely maintained over a longer period.
If even the best fund managers are unable to consistently predict the market’s direction, what should an individual investor do to ensure he takes advantage of the bull markets and stays out when stocks crash?
The answer is to only pick one of these two objectives, because in the absence of reliable market timing method they are mutually exclusive. You either invest in the stock market and take the bad (the occasional crash) with the good (the long-term growth), or you stay aside and keep your money in bonds or in a savings account.
If you invest in stocks, you will have to accept higher volatility and unpredictability, but in the long run you will be rewarded by higher return relative to bonds or cash. However, to make sure you achieve this higher return, you must resist the temptation to sell when the market “feels expensive” or when some analyst or salesman is persuading you to switch from stocks to some other “hot investment opportunity”. In the stock market, the real fortunes are made by patient waiting, not by frequent buying and selling.
One method which can be very effective for long-term stock market investing is to regularly buy stocks (or an index fund) for a fixed amount of money. For example, every month you buy shares for £1,000. When the market happens to drop, you will be able to buy more shares for the same amount of money. When the market is high, the number of shares you buy will be lower. This way you will buy more when stocks are cheaper and less when they are expensive. It is known as dollar cost averaging.
The key to success is applying this method consistently and not selling your shares, even when you feel like the market could crash. Although a crash will inevitably come at some point, the market will eventually recover, as it did after the 2008 crisis and after any other bear market in history. Besides, with the cost averaging method the volatility will give a disciplined investor an opportunity to buy shares at a discount.
Of course, this assumes that your investment time horizon is long enough. When you get close to retirement and are likely to need the money in the next few years, you should (perhaps gradually) switch from stocks into less volatile assets such as bonds or cash.