Buy and Hold versus Timing the Market
Have you ever asked yourself the question…why didn’t I buy shares in stock X when they were trading at an unusually low price or sell stock Y at its peak when I had the chance?
In this lesson we’ll review why it’s time in the market, not market timing that will typically make you money. In the next we will take a look at the 10 common mistakes investors make and how to avoid these common traps.
In the last of this series, you’ll learn that the best way to measure how well your investments have performed is to compare your performance to something else. That something else is an index. Index comparison may give you a new perspective on your portfolio’s performance.
In this section, you’ll…
- Learn why it’s time in the market, not market timing, that will typically make you money.
- Check out your chances of making, or losing, money in the market.
- Learn that the longer you invest, the lower your exposure to risk.
Stock Prices Fluctuate – But You Shouldn’t
Investors have a very common fault: They tend to believe their gut gives them a sixth-sense about just where stock prices are going.
The problem is, stock prices are anything but predictable. Take a look at this stock chart for NORTEL NETWORKS (ticker symbol NT on the NYSE).
This could be a five or ten year price chart. Well surprise…it’s actually for half a day! That’s right – just four hours of trading are represented here.
Don’t Get Seduced By the Market’s Short-Term Swings
You’ve just learnt a very valuable lesson for free: Invest on the latest direction of the stock price, and you’re almost guaranteed to lose a lot of your savings.
Don’t try to base your investment decisions on short-term price movements. Stock prices leap up, fall back, dart up again, pause, race ahead, slow down, change direction…all without warning, and usually without a discernable pattern. The same is true of the overall stock market since most indexes behave in a similar sporadic fashion.
There are two major mistakes you can make with choosing investments using short-term movements. Let’s look at them in turn…
Invest on the latest direction of the stock price, and you’re almost guaranteed to lose a lot of your savings.
Mistake #1: Investing at the wrong time
Just because a stock price had moved up yesterday and the day before doesn’t mean the price will continue rising tomorrow and the day after. All that the two days of continuous price increases can tell you is that, well, the price has gone up for two days running.
The next day investors may have a change of heart. The economy may take a hit. Or the company may release bad news.
Or, more often then not, investors may just decide that in the short-term, that particular stock’s price is a little too high. Buyers won’t be willing to pay that price, and those who want to sell their shares will have to settle for less. And so, the price falls.
Mistake #2: Not investing at the wrong time
We only say this somewhat tongue-in-cheek. No matter how great a particular stock might be, it will always go down as well as up. Neither individual stocks nor stock markets as a whole go straight up.
When you buy a stock, there’s always a chance that at some point in the future – perhaps even the next day or the next ten minutes – the price will be lower. Or perhaps the stock just stays flat.
But remember this: Just because a stock price has fallen or suddenly ceased moving upwards doesn’t mean you’ve made a mistake. That’s simply the nature of stocks.
But the problem some investors encounter is they remain paralyzed by what may happen.
It’s easy to think that it’s wiser to avoid ownership-type investments and stick with guaranteed investments such as treasury bills entirely. After all, they protect you from having to take on the real possibility that your investment will plunge in value.
One big risk of going the risk-free route is this: If you don’t invest at least some of your savings in growth investments such as stocks, your savings may not grow sufficiently to provide you with the wealth you desire or need. In the worst-case scenario, you may not even maintain the purchasing power of your savings due to the ravages of inflation.
When is the Right Time to Buy?
In general, if you have money designated for the market, get it into the market. Obviously, if stock indices are free falling, you may want to wait out the correction. But even when the overall markets are faring poorly some stocks are zipping upwards.
The key is not to focus on the overall market. Instead, focus in on stocks that meet your criteria as we reviewed earlier on.
Lessons from the High-Tech Roller Coaster
In any one day, week, month, or even year it’s tough to know just what’s going to happen. Take the years 1999 and 2000.
At the beginning of the year, things had never been hotter…especially for the shares of technology companies. Take a look at this chart of the tech-heavy NASDAQ index.
Lessons from the High-Tech Roller Coaster
In the last few months of 1999 and into the beginning of 2000, the index soared. In just 9 short months – July 1999 to March 2000-NASDAQ doubled in value.
As NASDAQ approached its peak, some observers commented that the market was overpriced. But many others weren’t so sure. After all, those same cynics had been saying the market was too high for months. Many investors looked at the charts and thought, “Hey, it’s gone up like crazy, but why would it stop now?”
Well, stop it did. By the end of 2000, NASDAQ had fallen right back to where it had been just over a year earlier. All of the 100 percent gain vaporized!
What does that mean in real, hard dollars? Let’s look and see…
How Much Can You Lose…or Gain?
If you had invested $10,000 in the NASDAQ index at the beginning of the year, you would have been positively euphoric by early March. Your original investment would have been worth a cool $14,500 by that time.
Fast-forward just another ten months or so. It’s another – and nowhere near as pretty – picture. Your $10,000 would have shrunk to $7,500.
That’s an awfully big spread – selling at the bottom versus the top would have meant wiping out $7,000!
What are your chances of losing money in any given year?
Let’s look at some interesting facts based upon past market performance:
- Stock investors lose money on average one year in three.
- According to historical numbers, you have a 9 percent chance of losing more than 20 percent in the stock market in any one year.
- You have about an 11 percent chance of losing between 10 and 20 percent in the stock market each year.
- The chance of losing up to ten percent in the stock market in a year is 13 percent.
- Bond investors have around a 30 percent chance of losing up to 10 percent in a year.
- The odds are slim – only 6 percent – of losing between 10 and 20 percent in the bond market in any given year.
And what about your chances of making money in any given year?
- In any given year, you have a two-thirds chance of making money in the stock market.
- Stocks held for a three year period have average returns ranging between negative 1 percent and 33 percent.
- You have an almost one-in-three chance of making over 20 percent in the stock market in any one year.
- You have about a 12 percent chance of making less than 10 percent in the stock market in any one year.
- Bonds have a 14 percent likelihood of rewarding investors with gains ranging between 10 to 20 percent in any one year.
- The odds of making over 20 percent in the bond market in any one year are very slim – around 4 percent.
So how can you predict which year you should be invested in stocks, and which year your money would do better under your mattress? You don’t need to because there’s only one answer.
Think Long-Term, Think Strong Returns
The longer you’re able to stay invested for, the less you’re likely to lose. If you stay invested for at least ten years, based upon history, you’re basically assured of at least getting all your money back.
The trick, of course, is to leave your money invested in well-performing stocks. Don’t depend on where a stock’s price has been to predict where it’s going. You’ll end up getting wrapped up in rear-view thinking and a lot of second-guessing.
Of course, success long-term only applies if you have done your homework and put your money into stocks that have a solid track record and strong prospects.
Key Learning Points
- Stock prices are generally volatile, even within a single trading day.
- You’ll likely lose money if you invest simply based upon short-term price movements of stocks.
- Don’t waste time trying to figure out when to start investing in stocks. If stocks make sense as part of your overall asset allocation, you can generally start whenever you have the money available. Just be sure to choose good, quality companies.
- As your investment time frame increases, the probability of those investments losing any of their value decreases.
- If you can leave your money in the stock market for 10 years or more, your chances of losing any of your original investment are almost zero.