Friday, October 1, 2010

The Moral of the Story Is...

A few days ago, The Wall Street Journal's Brett Arends penned an article entitled, "You Should Have Timed the Market". Arends bases his assertion on the fact that recent research from TrimTabs indicates that regular investors bought into equity mutual funds during the boom and needlessly sold them when everyone was panicking and selling their positions. As a result, investor losses were pegged at $39 billion.

Arends points out that TrimTabs, "calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171."

The conclusion shouldn't be that we should time the market. Yes, we should buy when everyone else is selling. As was famously said, you should buy stock when "there's blood in the streets". However, by tacitly agreeing to market time, you are setting yourself up to head down a very slippery slope. By engaging in this, you'll soon see that you find yourself jumping into and out of equities at precisely the wrong times because your emotions play such a big role in investing.

For example, suppose you've held a stock for a few years and have done extremely well with it. You have done the appropriate research and realize that the stock is still undervalued and so you continue to add to your position. When the company releases a poor earnings report, should you sell because everyone else is? Of course not! It's almost always a bad bet to follow the herd and to let your emotions get the best of you. You should always have the courage to stick to your convictions until the underlying fundamentals prove otherwise.

Instead, rather than "timing" the market as Arends advocates, it's a better idea to dollar cost average (DCA). With this, you simply buy into your investment (index fund, stock, etc.) without paying any attention to the price. This is helpful because you'll find that over the long-term, your average purchase price will be quite small and it will make up for any of the problems you would have had if you had tried to time your purchases based on the prevailing "wisdom" in the market. Dollar cost averaging beats market timing - always.

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