Why Investors Shouldn't Try and Time the Market
The market is doing historically very well these days -- so well that many investors are wondering if maybe they should try and wait for the next correction before buying in.
On this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann explain why it's not a good idea to try and time the market, even when a correction seems imminent. Find out why so many of the most successful investors strongly urge against market timing, what dollar-cost averaging is and how investors can use it to diversify their investments across time, and much more.
A full transcript follows the video.
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This video was recorded on April 21, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It'sFriday, April 21,and we're talking about timing the market. I'm your host, Dylan Lewis, andI'm joined in studio by Motley Fool premium analyst David Kretzmann. David, how's it going?
DavidKretzmann: It's going well, it's a Friday so I can't complain.
Lewis: Andwe have a listener question to talk about. Those are my favorite episodes.
Kretzmann: Me too.It's a lot of fun and I'm excited to dive in!
Lewis: We got a question fromHunter, one of our listeners, a while back. It took a little time to get back to him, but I thinkthe reward for taking time and waiting is, we'llwind up doing a podcast episode on it. So,sorry, Hunter, you're finally getting the answer that you asked for.
Kretzmann: We're coming around.
Lewis: He wrote into the show and asked, "Thestock market seems to be highly overvalued. Fromwhat I last read, thelong-term average of the P/Eratio of the S&P 500has been about 15, and now it's over 26. Would now still be a good time to invest during this bull market,or would it be better to sit on some cash and wait for a while andhopefully see that market correction and invest then?"I love this question, and, broadly, I love gettinglistener questions. If someone out there is thinking something, chances are there are dozens or hundreds of Fools allthinking the same thing. Hunter, thanks for writing in. Ifother people have questions, industryfocus@fool.com. Let'sjump right into it, David. He'stalking about market timing. I think this is something that's on a lot of people's minds. If you consumefinancial news at some point over the last year, you'veprobably seen something along the lines of, "The market is due for a huge correction," right?
Kretzmann: You'reprobably been hearing that since 2009,since the Great Recession. It is a common fear, especially when you've had a multiyear bull market, and you have stocks hitting fresh highs on what seems like apretty regular basis. We haven't had many10% sell-offsover the past seven years. It's a good question, andit's something to keep in mind as an investor. Onaverage, the stock market declines about 10% every 11 months, or about every year. Then, you'll have a bigger 20%, 30% or more decline every three to five-plus years. As an investor, you want to expect the market to go down. That's justpart of the price you pay as an investor to get historically above-average returns with the stock market. But, I'll take acontrarian point here, since we will be talking about some of the potentially bearish indicators. Going forward right now, the market looks historically a little pricey when you look at the P/E ratio of 26. As you mentioned, the historic ratio tends to fall a little closer to 15 or 16 or 17. The forward P/E ratioof the S&P 500 right now is 18. That means,based on what analysts are expecting,the S&P 500 is expected to earn over the next year, right now the market is priced at 18 times those forward earnings. That shows thatexpectations are pretty high that growth will continue for the companies in the index. That's one angle. On a forward basis, if thesecompanies can continue to grow,maybe they can grow into the valuation, andyou don't necessarily need a big sell-off to revert back to those historical averages. That's one angle.
Acouple other things we're actually going to talk about on Motley Fool Money today as well, on our radio show, the housing market is still below its historical averages. The housing market hasslowly but surely been recovering since the Great Recession. Buthousing starts, which basically meansthe construction of new homes, is still below the long-term averages going back to 1960. As millennials now, people between the age of 18 and 34 in the U.S., they're now the largest demographic in the U.S. ahead of baby boomers. As people our age, Dylan, start to get closer to 30, they're thinking, "MaybeI don't want to rent a house anymore,I want to buy a house or even build a house," that does a lot to spur growthwithin the economy, because there's so much that goes into thepurchase and the upgrade on the renovation of a house. That'ssomething that can drive economic growth and spending over the long term. Just a couple things there. Yes, on the surface level, the market does lookpricier than normal. But there are some factors that make me think, itdoesn't necessarily mean you're going to have a huge crash right away. That'snot to say that's not going to happen. As I mentioned before, youwant to be prepared as an investor forsome sort of sell-off down the road.
Lewis: I think,to add to that, you look back over the last year and a half or so, and the market hasnavigated what I would say are two majorshocks to the system, one of them being Brexit,and the other one being the election of Donald Trump. Twobig surprises that the market reallywasn't anticipating. And yet,it has weathered it and continued to grow at this really great rate. I will lay out theargument for why there's probably a correction coming at some pointin the next decade to 20 years, andwhat the financial media narrative has been. Forpeople that aren't familiar, basically, the gist of it is,because of quantitative easing, which is basically the Fed gettingmoney into the economy,making borrowing very cheap,interest rates have been historically low. They've beenhistorically low for a very long amount of time. Because of those low yields,investors have been pushedinto equitiesbecause they're looking for better returns. That demand drives up stocksinto overvalued territory. That's what we see, that's the gist of all of these research notesthat are saying the market is overvalued. Really,that line of thinking totally makes sense to me. My collegeeconomics coming back, I totally see the dots connecting there. And Hunter brings up great points with the data here. Typically, theS&P 500 on a trailing basis, P/E somewhere between 10 and 20.
The problem, though, is thateven if you're right withwhat your thesis is, when it comes to market timing and deciding, "I'mgoing to wait three months to do anything," or, "I'm going to sell now because it seems like we're at peaks," isyou have to be right not only about the thesis, butyou have to be right but the timing and when you act on it, and it's really tough to nail both of those things.
Kretzmann: It's really tough. There are someinteresting dynamics at play,and it's incredibly difficult to predictwhere the market is going in the short term. You have a lot of experts from theInternational Monetary Fund, the IMF, andhigh-ranking economists who were predicting before Brexit and the U.S. election that ifBritain leaves the EU, andif Donald Trump is elected president,there's a very high likelihood that the market will crash. Andlo and behold, the market is hitting new highs as a result. It'salso interesting to look at whatWarren Buffett has been doing. We traditionally see Buffett as more in that value mode as aninvestor. Between the U.S. election of Trump andearly February, he was a net buyer of stocks. He bought over $20 billion of stocks, includingApple (NASDAQ: AAPL), which has been anincredible performer, and driving a good chunk of the returns of the S&P 500 this year. If a correction was coming, if a crash was coming, Buffett would be the last personI would expect to be buying stocks,because he tends to be a more conservative investor. To your point, Dylan,I think it's a great point,looking at interest rates. Interest rates are at historic lows. Wehaven't really navigated throughprolonged periods of such low interest rates. Whenlooking at investments, you have to look at the alternatives. If you're not going to invest in stocks right now, where are you going to invest? The U.S. Treasuries or bonds are yielding 2% to 3%, 10-Year Treasuries, which is very low. So,that's not very attractive. You could put it in your savings account, maybe 1%, if you're lucky, or less. So,you have to look at the alternatives. So,it's understandable to see why people arelooking at the scope of investment possibilities right now. And they're gravitating toward stocks, even though, yeah, they look, on average, pricier than theytypically have been. But compared to everything else, it still looks more attractive.
Lewis: Yeah. Bringing it backaround to some historical examples, Hunter's questionreminded me of news that was swirling in early 2016.I'm sure you remember this.There were several big banks,RBS(NYSE: RBS)was one,I thinkMorgan Stanley(NYSE: MS)was another, they put outresearch notes in January, and they were basically urging their clients to sell stocks. They were saying, "We see thesecataclysmic issues coming to the market." It was,again, largely due toquantitative easing stuff with the Fed, lowinterest rate environments, and what that does to equities over an extended period of time, or else some growth concerns with China at the time. And you look at the run that the market has gone on since January 2016, I think it's up about 20%. I think a couple things that underpin why it'sbetter to stay invested,even with the unpredictability of the market. There's a ton ofvolatility out there. Since 1928 -- this is a stat that I love -- theS&P 500 has lost 20% or more in six years --1930, 1931,1937, 1974,2002, and 2008. Aside fromGreat Depression years, in the following year of each 20% drop, the market has roared back with 25% or more return. So,the good and bad tend to follow each other very closely.
If you look at things on anindividual basis, as well,JPMorgan (NYSE: JPM)puts out this guide to retirement every year,it's kind of an overview of asset allocation,different strategies, and they also looked atthe impact of staying fully invested versus missing certain days in the market. Over 1996 to 2015, missing the 40 best days in the market takes your returnsnegative if you had been invested in the S&P 500, and six of the ten best days for the market during that period were within two weeks of the ten worst days. So,individually picking andlooking at these individual indicatorscan be really difficult, andoftentimes the market tends to flip very quickly. Again, getting to timing, it's reallydifficult to nail that down.
Kretzmann: Yeah. If you'rehesitant to buy today, youhave to figure out, what would make you a buyer of stocks? Would it be after a 10% drop? A 15% drop? A 30% drop? What are you waiting for to be a net buyer of stocks? Andmaking that kind of timing decision is incredibly difficult. That'swhy you have great investors likeWarren Buffett and Peter Lynch who say, "Do not do market timing,it's probably the worst thing you can do for your future returns as an investor." Often,psychologically, when the market is down 8%, you might think, "Oh,I'm just going to wait until it's down a little bit more,I'm going to wait for it to recover a little bit," and you get into these mind games where you'rehurting your future returns,because making that timing decision of both when to buy and when to sell, it just raises the probability that you're going to mess up somewhere along the line. As you've outlined in a nice way, Dylan, the key is to be invested through the good and the bad times. I know later in the show, we'll talk about somedifferent ways that you can invest in a waythat you're still comfortable and you're sleeping well at night,which is what you should do.
But the best thing you can do as an investor, the main advantages you have, here at the Fool, we believe, first, in,investing in individual companies. So, you have to factor that in. You'renot necessarily buying an index fund, or buying a whole collection of companies. You'refocusing on individual businesses. As an individual investor, your main advantages are, you can try to find and invest in and hold the greatest businesses out there -- the Apples, theAlphabets (NASDAQ: GOOG) (NASDAQ: GOOGL), theFacebooks (NASDAQ: FB), theAmazons (NASDAQ: AMZN), those kinds ofcompanies -- and thenyou can also hold for a really long time. OnWall Street, the average holding period for a stock is now less than six months. Back in 1960, it was over eight years. The average holding period for a stock today is weeks or months. But,as an individual investor, you can say, "I'mjust going to tune out that short-term noise.I want to invest in great businesses.I don't care about what's going to happen over the next year or two, I'm more interested in, what isAmazon or Facebook or Apple going to look like in 10 or 15 years, notwhat they're going to look like in the next year." So, as an investor, the best thing you can do is lengthen your holding period, or your time horizon. Our former Foolcolleague Morgan Housel has done someincredible research on this,looking back at historical S&P 500 data going back to 1870. He found, if you had held a stock for one year, basicallylooking at every incremental one-year periodgoing back to 1871,if you just held for one year,it's basically like flipping a coin. One year you will be up, one year you'll be down. It'sflipping a coin, basically gambling, if you're justtrying to predict where things are going to go where things are going to go over the next year. But if you lengthen that out to five years, 10 years, 20 years, the odds of you making money at the end of those longer holding periods increases each time. There's actually been no 20 year period that if you had bought and held theS&P 500 over 20 years whereyou lost money. That's after inflation. That includes the Great Depression, itincludes the Great Recession. Really, the message there is, the No. 1 best thing you can do as an investor toguarantee higher returns is to lengthen your time horizon.
Lewis: Youtalked about investing in individual companies.I think that's something that can get lost in the huge macro stories we see. Very often, will something that is a sweeping macro issue really impact a company likeFacebook? The fundamentals that underlie the businesses that you'reinvesting in probably aren't touched all that much by something like rising interest rates. Yes,it will at least be something that impacts of broad market, but they still have the user growth they have,they still have the base of advertisers that are happy to put stuff on their platform. So,you have to remember that you're investing in the individual business, and while it's scary that theremight be some rumors circulating aboutcataclysmic stuff going on in the market, thefundamentals of that business are really what's underpinning your investment.
Kretzmann: Definitely. Within theOdyssey IIportfolio in Supernova that I head up with a team of a few other Fools, I will admit that we are having aharder time finding glaring bargains with individual companies right now. Stocks are, for the most part, more expensive than they typically are. Youget outside of your comfort level a little bit. But we're tasked every month withmanaging this real money portfolio,and we have to make a purchase every month. Theapproach we take there is justfocusing on the individual businesses. We'll build up positions in companies over time. I think at a time like this, you want to build positions in companies that you'll be comfortable adding to if they go on sale 20%, if they go down 20% to 40%. So,maybe that's Amazon, maybe it's Alphabet. Whatever it is,companies that you feel pretty confident will be around over the next 10-15 years,companies that are generating strong cash flow,maybe they pay a dividend,maybe you start with a small position and then say, "You know what?I would actually really be happy if I could buy this company for a 30% discount, because I don't care where it'll be in a year or two. I'm moreinterested in the next five to 10 years or more."
Lewis: David, wetalked about how market timing's hard,and I think that gives a lot of people this impression of, "What the heck am I supposed to do?" The market is rich right now,we just talked about that. What's ouradvice for investors here?We teased it a little bit in the first half. How do you go into thesemarket conditions and think about placing money? You talked about the Odyssey portfolio little bit,obviously, you personally invested as well.
Kretzmann: Yeah.I would say, on a higher level,you want to invest in a way whereyou're sleeping well at night, you'refocusing on the underlying businessesin your portfolio, assuming you're investing in individual stocks, which,you probably are, if you're listening to this show, you'refocusing on the long term, andinvesting in such a way that you see a market drop as anopportunity and not something to fear. There are a few ways you can go about that. One of theeasier ways is dollar-cost averaging, where you say, "Every month,I'm going to invest a set amount." Thisis especially easier if you're workingin your life and have a regular stream of income thatyou are contributing every month or quarter to your portfolio. Say, "Granted,the market looks a little bit pricey now,but I'm going to invest a little bit every month, I'm not going to pay attention to the price too much,I'm just going to find companies that I really like, ormaybe an index fund, and I'mjust going to invest a little bit every month, every quarter, insome sort of increment that makes sense." Anotherapproach that we use in Odyssey II is,maintain a cash position. For some people, that might be10% of their portfolio. If you're really conservative and you recognize, "Ifthe market goes down 40% 50%," whichprobably will happen about every decade or so. You shouldassume that will happenat some point. Maybe you want 40% of your portfolio in cash. And you're fine recognizing that "I might miss out on some of the upside, but I'll sleepa lot better at night, and I won't panic when the market drops."
So, it's really just a matter of evaluating your own psychology and psyche as an investor. And you should probably assume you'll be more scared than you think you'll be. Because it's really easy when the market is going up to say, "Yeah, I got this. 10% drop? Bring it on." And then it happens and you're panicking, you're like, "Oh my gosh, I need to sell, I'm not going to buy." You really want to be cautious with your approach. You want to assume you'll be more scared than you think you'll be when the market drops. Go in with that assumption. But, build your portfolio around the understanding that market drops will happen, but invest in such a way that you won't let those drops get to you, that you'll continue to stay focused on the underlyingbusinesses behind the stocks in yourportfolio, because the long-term performanceof those businesses is,in the end, what will drive the performance of those stocks. If a recession comes, or a market crash comes,it doesn't matter how great the business is,just about every stock is going to get hit a good amount. That'swhat happened in the Great Recession. You had great businesses likeStarbucks(NASDAQ: SBUX)-- it's coffee,it's not going anywhere, but still the stock got hammered. Again, you want to invest in a way that you're focusing on the underlying businesses, the long-term performance of those businesses, staying focused on the long-term as an investor, and sleeping well at night.
Lewis: Yeah. I think,regardless of market conditions, it'salways good to have a little cash on the side,because even in a raging bull market,if you have a stock you really love that reports iffy earnings because of some one-off charges orsomething like that and the market reacts poorly and shoots it down 7% or something, that might be a good buying opportunity. I know Kristine Harjes, the Healthcare host, did anepisode a little while back about the importance of having a watch list, and some cash on the side so that as opportunities come up, you have the flexibility to act on them. I think that'sdefinitely one thing to keep in mind. I thinkanother thing with investing is, yes, it's a bull market right now, but when you're buying shares,I think a next-level investing type thing is, you're buying bits of shares. Youdon't want to buy your whole position in one transaction. You want to slowly build to the position you want. That gets at that dollar-cost averaging. If you want to eventually hold $3,000 of Facebook stock as currently valued, maybe you invest $1,000 now, $1,000 in a couple months, and $1,000 later in 2017 so that you get that nice blended average of cost, and you're less susceptible to one really high point in the market, and one really high point for Facebook stock.
Kretzmann: Yeah. Diversification is really key on a lot of different levels. First, you want to diversify your portfolio across different companies that you're comfortable with, you believe in for the long term. But what dollar-cost averaging does is it diversifies you across time. If someone started investing in late 2007, they have apretty bad perception of the stock market, like, "This stinks,why does anyone do this?" On the other hand,if you started investing in March 2009, you're like, "Manthe stock market is so awesome, this is so easy, this is shooting fish in a barrel." But,if you can diversify over time and ease into the positions in your portfolio over time, that way you have less risk as far as time exposure. We commonly think about diversification across the businesses or stocks in the portfolio, but you also want to think about diversification in terms of time, and dollar-cost averaging is definitely one way to do that.
Lewis: Yeah, I think that's a great point. Maybe we can't provide personal advice to Hunter, but I think someone in Hunter's position, where, maybe you're relatively new to investing, you have some cash you're interested in, maybe it's, slowly start to take bites, and get a better understanding of the businesses you're investing in, and maintain some cash position so that as there are deals that become available in the market because of minor dips here and there, you have the opportunity to continue to act on them.
Kretzmann: Definitely, yeah. LikeI mentioned earlier, I knowI've been repeating myself a lot in this episode but it's such a key point,you want to set up yourportfolio in a way that you seen a drop as anopportunity, not something to fear,because the drops are inevitable. This bull market could continue for the next three years, we could have a 20% drop next month. No one knows. Again,even the experts got Brexit and the U.S. election totally wrong. Andthat was a consensus expert opinion, it wasn't controversial what they were predicting. Just assume, understand that a drop will come at some point. It could be next month, it could be five years from now. But invest in such a way that when that drop comes, you see it as an opportunity, and not a reason to succumb to fear.
Lewis: Yeah. I think that's a good point to end on. David, thanks for hopping on the show!
Kretzmann: Anytime, Dylan. Thanks for having me!
Lewis: Well, listeners, that does itfor this episode of Industry Focus. If you have any questions, or if you want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. Like I said, I love getting those questions for episodes. You can always tweet us @MFIndustryFocus, as well. If you're looking for more of our stuff, you can subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. David Kretzmann owns shares of Alphabet (C shares), Amazon, Facebook, and Starbucks. Dylan Lewis owns shares of Alphabet (A shares), Apple, and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, and Starbucks. The Motley Fool has a disclosure policy.