This question is constantly being asked by many investors around the world. Is it better to wait for a pullback in stock prices and then invest, or should you buy an index fund and forget about it for a long time? Peter Lynch famously said, that more money has been lost anticipating corrections than in the corrections themselves.
First, let’s look at the 100-year chart of the Dow Jones Industrial Average:
During this timeframe, the world experienced two world wars, many smaller armed conflicts, several periods of deflation and high inflation, oil shocks, trade wars, the ascent and descent of communism and many other problems.
In 1919, the DJIA was at 100, today it’s at 26,800. That’s a roughly 6% return per year during those 100 years, and that doesn’t count dividends which averaged about 2%, which gets us to an annual return of 8%. That’s not so bad, considering that US real estate returned around 6% per year during that timeframe and bonds around 4-5%.
In the chart we can also see the devastating crash of 1929, during which stocks lost almost 90% of value. Compared to that, the bear markets in 1974 and 2008 look like a walk in the park.
So what would happen if you were the unluckiest market timer in the world and always bought at the top? This article gives us a pretty good picture, it talks about a hypothetical investor named Bob, who invested right at the peaks of bull markets in 1972, 1987, 2000 and 2007. After a total investment of $184,000 thousand, he’d be left with $1.65 million (adjusted for the fact that the article came out in 2014), which is really not bad considering he invested only at the worst possible times.
In his famous book, The Intelligent Investor, Benjamin Graham reminds us that an investor must be comfortable with the fact that prices will swing wildly from time to time. In fact, declines of at least 50% are common in the markets. Most people are afraid of such declines, but they provide us with great opportunities to acquire some of the world’s finest businesses for bargain prices.
As Charlie Munger, Warren Buffett’s business partner at Berkshire reminds us in this video: “If you’re not willing to react with equanimity to a market price decline of 50% 2 or 3 times a century, you are not fit to be a common shareholder and you deserve the mediocre result you’re going to get.”
There is no way of owning common stocks without going through periodic painful declines. If an investor is not prepared for them, then perhaps he or she shouldn’t own stocks at all. There are other alternatives like bonds, real estate or certificates of deposit. Common stocks offer higher returns than all of these classes, but also experience significantly more volatility. There are always many risks on the horizon and future is never certain.
If you are always too optimistic regarding future stock prices, you can get caught in a really nasty bear market. On the other hand, if you are always too careful, you might never invest and then you miss the large gains that common stocks offer.
So what can an investor do?
Benjamin Graham discouraged investors from market timing in his book, but he also offered 5 indicators, based on which one could judge the approximate level of euphoria in markets:
- A historically high price level
- High price/earnings ratio compared to history
- Low dividend yields measured against bond yields
- Rampant speculation on margin
- New IPOs of very poor quality
Howard Marks, a successful value investor and founder of Oaktree Capital Management also lectures, that when we’re high in the cycle, it’s usually characterised by optimism, enthusiasm, greed, risk tolerance and credulousness.
If you see any of these indicators or a combination of them, you can be sure the market is getting more dangerous and it’s probably a good idea to invest a slightly smaller sum and maybe go into bonds as well.
Going into cash looks good on paper, as you can buy stocks cheap when they go down. Cash doesn’t lose money, but it also doesn’t make any. If you stay in cash too long, you might miss the subsequent advance and never invest again. Plenty of investors who got burned in the 2008 crash sold out their entire portfolios and never returned to stock markets again, missing the incredible bull market that began in 2009.
The markets are full of very smart and successful people, but only those that have the stomach to endure the ups and downs are the winners in the long run. Once you realize that you don’t need to time the market, but rather buy right and sit tight, you will feel no need to try to guess where the markets are heading in the next month or year. An investor who bought an S&P500 index fund in October 2007, would have made roughly 2.4 times his money in the twelve years up to now (with dividends included). That’s an 8% annual return, which is not bad at all and roughly in line with the historical average.
When Warren Buffett was asked, what’s the most important trait that separates professionals from amateurs in the stock markets, this is his reply: “The most important trait an investor has is temperament. He needs to have a stable personality. You don’t need a very high IQ in investing, but you must not derive pleasure from being with the crowd or against it, you must be indifferent.”