Keep Investing During Market Declines

I had a recent question from a reader as follows:

I am 23 years old with no credit card debt.  I live with my boyfriend, who is 24 and also has no CC debt.  We both have student loans and each have a car loan (although we both hope to buy our next cars with cash).  We have 401K plans through our employers and each contribute 6% to get our respective company matches.

From reading your blogs, I know that you are a big proponent of index funds.  Back in October, I opened an S&P 500 index fund with Vanguard (VFINX).  I set up automatic transfers of $400/month to the fund.  My boyfriend has a Roth IRA in which he also invests in a few index funds and a money market cash reserve earning 5%.  As a result of the poor market conditions we have recently experienced, he has moved the majority of the money in his IRA from the index funds to his money market reserve for the time being.  He is planning on moving the money back into the index funds when the market gets better. 

On the other hand, I have continued investing in my index fund, as I am only 23 years old and am planning on keeping the fund for 20+ years.  I figure I can risk riding the ups and downs of the market because in the long run, due to dollar-cost averaging, I will earn good returns and more than make up for the temporary market slump.  My boyfriend argues otherwise.  Is he correct?  Should I temporarily stop investing in my index fund and instead invest my money in an online savings account (I currently have one with HSBC) or other stable investment vehicle? 

I'm sure you get inundated with e-mails from readers on a daily basis, but I would truly appreciate your thoughts on this.  My boyfriend and I have been arguing about this for a few weeks now, and it would be nice to get an opinion from someone who has had experience with index funds for an extensive period of time.  We both are huge fans of your blog and would highly value your opinion. 

Here was my response:

No, he is not correct -- you are doing the right thing.

No one knows when the market will go up and down and it's been shown that in order to make the most out of the market, you need to be in the market at all times. If your boyfriend misses the upswing (which is quite common since no one knows when it will happen), he'll do what many who try and time the market do -- he'll miss everything. He may think he won't, but there are million-dollar mutual fund managers who try and time the market like he's doing, and if they can't do it, neither can he.

Keep investing, especially since you have a very long time horizon, and you'll be rewarded when the market rebounds. It may take a year, three years or even a decade. But it will eventually reward you for your consistency.

Also, you may want to point your boyfriend to a few of the articles (search Google) that say if you just miss the top few % of the days where the market gains, you lose almost all the advantages (and return) of investing in stocks.

BTW, I'm 20 years older than you and I'm still investing a good amount every month into the market. When it goes down, I get cheap funds that I know will rebound nicely at some time. ;-)

Hope this helps!

I didn't have time to search for the articles myself when I replied to her, but I've had the time since. Here's what I was talking about when I noted that missing the top few days in the market can really hurt your investment performance:

Numerous studies have shown this to be true. One of the most famous was done by Ibbotson Associates & covered a 40-year period. What they found was that a fully invested $1,000 became $86,550; but if you missed the best 1% of the time, you ended up with $4,492. Another study by the U. of Michigan covering 30 years confirmed that being out of the market for the best 1.2% of the time lost 95% of the profits.

You see, the reality is that the market tends to go up in short bursts, which usually happen before the timers can jump back in. No one rings a bell when the market is ready to reverse direction. The big risk of market timing is being out of the market at the wrong time.

Let’s look at the 12/31/91 to 12/31/01:

• S&P return was 12.94%
• Miss 5 best days: 10.29%
• Miss 10 best days: 8.18%
• Miss 20 best days: 4.71%
• Miss 40 best days: -0.56%

Here's another -- this time from FiveCentNickel:

As you can see, missing out on the biggest days has a huge impact on your investment performance. What makes this is all the more sinister is when the biggest days happened. Looking solely at the top 10 days in terms of percentage return, 3 of the 10 best days overall occurred in the 10 days following Black Monday in 1987, whereas 4 more occurred during the tumultuous bursting of the dot com bubble, including 2 right as the marketing was bottoming and starting to head back up.

In other words, if you lost your nerve in the wake of Black Monday, you would’ve missed out on a major rebound that included daily gains of 9.3%, 5.3%, and 4.9%. By the time you realized the world wasn’t about to end, you would’ve missed out on a big portion of the recovery. In other words, you would’ve truly sold low and then, once you got your nerve back, bought high.

And one more from Nickel:

From 1982 to 2001, the S&P 500 gained a 11.8% per year. Had you invested $10,000 at the beginning of this timeframe, you’d have $93,075 if you keep your nerve through the ups and downs and stayed in the market. In contrast, these are the returns if you jumped in and out and even slightly mis-timed the sometimes dramatic recoveries from the bottom:

• If you missed the 10 best days, you’d have $56,044
• If you missed the 30 best days, you’d have $28,144
• If you missed the 50 best days, you’d have $15,780

Considering that there are roughly 250 trading days in a year, this means that missing out on the best 0.02% of the investing days over this 20 year period (i.e., the best 10 of 5000 days) would’ve reduced your total return by nearly 40%! In contrast, if you’d sat tight throughout, you’d be sitting pretty right now.

To summarize, if you have a long-term investment horizon (ten or more years), you should keep investing regularly no matter what the market is doing. When the market drops, you'll be buying more shares at lower prices and when it turns around (which it will), you'll reap the benefits. Yes, those on the sidelines will have missed the drop, but unless they have some sort of psychic vision the rest of us don't possess, odds are that they'll miss the upward spike as well, limiting them to a sub-par investment performance.

Comments

[Foobarista]

The irony is the boyfriend's statement answers itself. You should want to push into the market when everyone's badmouthing it, the media declares the sky is falling, and the talk-shows are full of the various Chicken Little breeds. They'll helpfully talk the market down for you and let you "buy low".

When the market gets "better", it won't be low any more. If you believe that the market will EVER get better, you should be pushing in with retirement money if you're 22. About the only reason you shouldn't be pushing in is if you believe the US and its markets are fundamentally doomed, in which case you should be emigrating and not worrying about your IRA.

Buy low, sell high...

[Moneygeek]

While generally persuaded by your argument about timing the market, wouldn't the boyfriend also miss the WORST 10, 20, or 40 days in the market?

A further analysis of missing the WORST stock market days would be useful also.

[Andy]

FMF's comments are right on. All of the math and statistics (which are indeed important) aside, you can help motivate yourself this way: if your investment timeframe is 20+ years, then it's a *good* thing when the market price goes down -- it's like the shares are on sale, so you get more of them for your fixed budget. If you don't buy when the prices are low, then it's like waiting until the sale is over to make your purchase.

In an idealized sense, you want the price of the shares to be rock-bottom for the entire time you're buying them (buy low), and then through the roof on the day you go to sell them (sell high). Markets don't work like that, of course, but dollar cost averaging is a good way to smooth the curve out over a long period of time.

[FMF]

Moneygeek --

Just like no one knows the best days of the market (and the only way to capture them is to be in the market), no one knows when the worst days will be. The only way to avoid them with certainty is to be out of the market (which negates the impact of capturing the gains when they do hit.)

[Traciatim]

How about a strategy of 'double down when low'. I was trying to do the analysis of this and couldn't get it going properly, but here is basicly the strategy:

1) Setup a $100 monthly payment in to an index fund of your choice
2) Set a 'sky is falling' goal of X%
3) If the index is X% from it's previous high, double the $100 to $200 (stop buying your coffee that month or whatever you need to do)
4) Remain at this elevated contribution level until 3 is no longer applicable.
5) Wash, rinse, Repeat . . . for 30 years.
6) Retire Rich

I couldn't quite get my script to calculate the gains properly, but could someone out there give a hand and see if this is a viable strategy? It seems to me like it would be as good a strategy as any out there.

[Tim]

what concerns me is the boyfriend's Roth. one clarification is needed: is the MM reserve outside the Roth or an option within the Roth (i.e. a Roth MMF)? You can withdraw contributions at any time, however, if you do, you cannot replenish the Roth again for previous year contributions and will be limited to current year contribution maximums. moreover, if he withdrew earnings, then he has some tax consequences and potential early withdrawal fees. but i'm guessing it is an IRA cash reserve.

The Vanguard S&P 500 index fund has taken a wallop (i keep seeing our roth's decrease, although i'm not worried about it), but you definitely need to think of long term when looking at index funds. Your consistent contributions between oct and now, will offset. given that we are now below the 52 week low for S&P 500, continued contributions now will eventually (based off of history) increase. this is why the index fund is a lower risk vehicle. it may take some time, but you have to believe that the market will eventually increase over time; otherwise, you wouldn't be taking the risk in investing in the first place. If you can, increase your contributions now, since the market seems low, and then just wait it out.

The other disadvantage of moving money out of the index fund or any other fund is that the boyfriend may not be able to reinvest into the same fund for at least 90 days, since he withdrew from the fund (see your fund's management policies). This is the problem with trying to time the market in terms of finding a low and a recovery. If you are locked out of the fund, then you could pay more than what you sold to begin with. you could transfer to a different IRA manager, but then you could be assessed a redemption fee, which again takes a bite out of the overall earnings.

Your boyfriend also needs to take into consideration that the market since oct has been doing plenty of 200-300 point gyrations. trying to figure out when the peak or valley will stick or bottom out, is going to be very difficult when the market has a standard deviation of 200 points. I think with this kind of spread, you are taking far more risk in determining peaks and valleys than you are with riding it out.

what may have to happen first, though, is your boyfriend probably needs to re-evaluate his risk tolerance and overall diversification of all his investment assets. Diversification can mitigate risk. If you are planning on staying with him, you also need to understand each other's risk tolerance levels so you finances don't become a point of argument every time the market fluctuates.

[FMF]

Triciatim --

Your proposal is similar to what I do:

http://www.freemoneyfinance.com/2007/04/what_i_do_when_.html

[Lauren]

Here's a similar question that I'm wrestling with -

I'm 23 as well, with a 401k through my employer. This year we switched providers (from Fidelity to some shoddy company with a shoddy website and semi-okay funds, but that's another story) and our Fidelity funds are remaining out there for a few months until they are transferred into our new allocations.

With the market going down as it is for the next few months, would it be a good idea for me to change my funds (which are dropping 5% per day lately) to bonds for the remainder of the time they are there? I really don't like seeing all my hard work going down the drain so quickly, especially since I won't benefit from buying the cheaper funds.

[Tim]

Lauren, who knows. It could go down further, it could rebound, it could remain flat. Evaluate your risk tolerance, look at the big picture, and then make your decision. You'll be kicking yourself if the decided to switch to bonds now in the mean time, and then the market increases right before the change over. Then again, you'll be kicking yourself if your funds continue to drop and you didn't move your funds into bonds during the change over. Given the fed will invariably decrease rates at the end of the month and congress, in an election year, will more than likely act quickly on a short term fix, and given various economic reports, it is going to be very difficult to determine when the best time to jump in and out of the market over the next two quarters.

if you are invested in index funds, then you just have to hang on for the long run since history suggests index funds appreciate over a long period of time. if you are invested in sector specific funds, then you might rethink the health of that particular sector. the other thing to consider is how diversified you are in your overall portfolio, not just your 401k, ira, or cash savings.

[Matt]

I'll go ahead and pile on here. The boyfriend is dead wrong. On the off chance it works out better for him than the girlfriend, it will be because of sheer dumb luck.

The point about missing the market's few best days is correct and important, but there are many more reasons as well. I'll list just one or two.

One of the great things about an S&P 500 index fund (or better yet, a total market index fund like VSTMX) is that it WILL be back...unless of course there's a nuclear war or something, in which case all is lost anyway. So, if you have more than 15 years to wait it out in case it's slow to come back, why not buy when it's on sale?

It amazes me what backward thinking people have about the markets. Selling after your equities have lost value can only lock in your losses. Moving the money back into equities "when the market gets better" is nuts. When the financial media is no longer gloom and doom, it's already too late...you missed out. Trying to time the market like that will only lead to selling low and buying high.

On the other hand, it's possible to get carried away in the other direction. You think: "I gotta put every last cent I have into equities because the market just had a big drop." That will get you into trouble too, because you're still trying to time the market. The stock market can go up or down tomorrow, and yesterday tells us next to nothing about which it will do. So dollar cost averaging is the most sensible way to go.

To the girlfriend: you're right about market timing, but I do worry that you're not diversifying enough. In your situation, the cheapest, easiest way to diversify right now is Vanguard's Target Retirement 2050 fund (VFIFX). It's a fund of index funds. I wouldn't keep it forever, just until you have a large enough portfolio to do your own diversifying without incurring too many fees.

[planner]

The reader is sticking with simple dollar cost averaging by investing $400 per month. That is an easy, quick plan that works over the long term. I agree she should stick with it since it works for her.
The boyfriend is taking a very aggressive approach based on his understanding of how markets move and his prediction that he can time it now. He should look into it and figure out how unlikely it is that he can really beat the market, it is rare. But it does happen. I know someone who invested successfully back around 1999, made a bunch of money, and got out before the bubble burst. If the boyfriend understands the risk I would look at how much he has in the account that he is betting with (timing is pretty much gambling most of the time). He's not completely out of the market, since it appears he has a decent 401(k) strategy that is still invested in the market. He is young, and his Roth might be a small enough part of his assets that it is a small gamble. If he can step back and see the big picture he can decide what to do. If he goes through with it and loses, hope he learns from it. If he goes through with it and wins, hope he realizes that it won't always work and over the long term there are better strategies.
I agree with Moneygeek also. You have to look at other statistics other than just missing the best 10 days. Pushing that argument is suggesting that one of the 10 best days will pop up before the market looks better.

[Corey]

Hi. I generally agree with the sentiment of the post, but I also agree with Moneygeek who commented earlier that the analysis of returns if you miss the N best days is heavily biased in favor of not trying to time the market. I would also be interested in seeing the overall returns if you missed the N worst days and/or the N best and worst days or N random days.

Just like you said, FMF, since no one knows with certainty whether a particular day will be good or bad, it's just as likely to be out of the market on a bad day as it is to be in the market on a good day, so for that reason I think it's fair to want to see both sides of the numbers.

[Jeff]

I apologize if anybody has already noted this above...I first off want to commend them. To be young and be saving at all much less in the amounts they're saving in you can virtually do no wrong. Why invest in a 400/month in a taxable index fund when you can invest in a roth or the tax deferred (though not matched) 401k? Certainly could depend on what you intend to use the money for or even if you are uber blessed and 6% gets you to the 15.5k limit. Just a thought.

[Newbie]

So what do you guys make of work such as the following that show, both in theory and practice, dollar cost averaging is the wrong thing to do?

Constantinides, George M. (June 1979). "A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy". Journal of Financial and Quantitative Analysis 14 (2): 443-50.

"Nobody Gains from Dollar-Cost Averaging" in Financial Services Review (1992-93).
John R. Knight and Lewis Mandell

(I've been dumped on for my comments in 2 other articles on this blog - but really I'm starting to think that perhaps actual quantitative finance background is distinctly lacking)

[Ryan]

Corey,

I think what FMF said above is that the best single days of the market actually occur during bear markets, which makes it counterintuitive to try to time the market.

[MonkeyMonk]

Although I genrally agree with this piece I also agree with Moneygeek's comment that I find it strange nobody ever quotes statistics showing the imapct of sitting out the 10/20/50 worst days. While iit can be hard to time the market on a micro level it's not as hard to forecast the major corrections. It didn't take a genius to guess where the market was going in 2001/2002.I pulled about 75% of my funds out of the market during this correction and bought back in during 2003. I messed up on my timing a bit (I missed the peak by about 10% and I missed the trough by a good 20%) but that amount in the middle made me quite a bit of money.

Ironically, even though I missed a number of those "best days" during this period, the net movement of the market as a whole over this same period was a loss. I was glad to have missed them.

[MonkeyMonk]

One thing I forgot to mention . . .

One of my biggest complaints about those "Best Days" statistics is that they assume someone who was in the market for 40 straight years who just managed to sit out the single exact days that the market rallied. This is a fantasy situation that doesn't describe anyone I know who actually tries to time the market. When they do sit out they often sit out for a few quarters or more.

[Matt]

Market timers, you're getting too fixated on this best days/worst days stuff. Here's the bottom line: you're not clairvoyant.

Have a look at this: http://www.ifa.com/12steps/step4/

[FS]

I'll second Matt.

From the Motley Fool website:

"Some investors believe they can "time" the market, meaning that they think they can tell when the market will go up and when it will go down. As a result, they counsel selling all of your stocks when the market is going to go down and buying them all back when the market is going to go back up. Unfortunately, if it were that easy these same folks would be sunning themselves on beaches in Acapulco and not trying to sell newsletters. Certainly when the overall economic scenario gets bad enough to hurt corporate earnings growth and companies start to flounder, you might consider selling some of the lower quality companies that are overvalued - but a system to consistently time the market as a whole has been about as actively pursued as alchemy, and at this point is about as realized."

Source: http://www.fool.com/school/basics/basics08.htm

[MonkeyMonk]

I'll admit I'm being a bit of a devil's advocate here. Buying index funds for the long-term is an excellent strategy but by their very nature will tend to return you average results. The more broad-based they are the more average the result. Because of this I've always preferred a sector-based diversification of a larger number of index funds and ETFs. This ways when certain sector is in the toilet I can shift the portfolio out of those sectors and into more stable area. Sometimes it just makes plain sense to sit things out for a while.

I've been out of the finance and REIT sectors for about a year now and if I had "stayed the course" like so many people recommend I would have seen my portfolio in these sectors decrease by 30%-50%. I've already started buying back into finanace by buying a variety of ETFs that track this sector. Will it continue to go down? Possibly -- and if it does I'll continue to buy more shares with the money that would not have been available if I had kept it all invested.

Another example: I've been a happy Berkshire Hathaway stockholder for over a decade. Someday, poor Warren Buffett is going to either retire or (more likely) pass away. I will be out of that stock as soon as I hear the news because it will go down. Way down. Anyone who thinks otherwise is deluding themselves. Ironically, I think there's still a lot of value with BRK and will probably buy back in once it looks like the dust has settled and things are starting to level out. Why as an investor should I ride out the bad news?

[kitty]

@MonkeyMonk:
I just bought into BRK.B a couple of days ago so I wonder about about Warren Baffett as well. What worries me is that if something happens with Warren Buffett, a lot of people will think the same way you do. So, the whole thing may immediately drop considerably before an individual investor has a chance to sell at a reasonable price. Hope it's not for a while as I plan to buy a few more BRK.B shares in the near future.

I am starting to wonder about financials as well as about the right time to go back to REITs. I avoided it because by the time I noticed our 401K offer it, I already suspected real estate bubble. I think real estate may drop more, though. By the way, what do you think about international REIT? My company just added it to our 401K choices.

Incidentally, I wish I was smart enough in 2000-2001 to get out. Had I done it, I'd be 40% richer now. I was overinvested in the technology stocks outside of 401K and got greedy and not sold. I do think that sometimes it may sense to time. Maybe not trying to capture worst weeks, but at least selling when there appears to be a bubble.

[FMF]

MonkeyMonk --

"Buying index funds for the long-term is an excellent strategy but by their very nature will tend to return you average results."

If by "average" you mean "more than 70+% of all mutual funds", then I agree. The key: look at returns AFTER expenses. Index funds will be the best returning alternative in most situations.

[MonkeyMonk]

FMF . . . I couldn't agree with you any more -- it's all about low fees. That still doesn't stop an index from being average. They're forced to return an average return by their very nature. I have about 80% of my portfolio socked away in a diversified blend of index funds and ETFs. I think where my strategy would vary from yours is that I keep a fairly specialized blend of indexes and ETFs rather than a borad index. This way I can come in and out of sectors as I feel the market warrants.

[Rosemarie]

Well, a month ago, I would have agreed with the young lady, but now I'm starting to agree with the boyfriend. Of course, I'm almost 50, and only about 15 years away from retirement, but I lost everything I earned in equity-based mutual funds in my retirement account in less than 2 months. I am back to the position I was at in 2005. Normally, I am someone who "sits tihgt", except during the 2001 debacle, I pulled out early and was one of the few people who didn't lose money that year, and then was able to climb back in and get good earnings on my principal. I have just pulled out and put everything in bonds -- I'm sitting this one out for a while, before my entire portfolio disappears. With some stocks dropping 10% a week, you could end up with nothing after 10 weeks. Right now, I'm anticipating retiring in near poverty.

[xshanex]

I am also a believer in the dollar cost averaging over the long term with certain restrictions. When my girlfriend finally received her rollover from her previous company it went in her account and she had no idea what to do with it. The market has been jumping back and forth for months now and after the big drop the last couple of weeks she put a little of it in index funds but is holding onto the rest as it earns 5% in the MMF and we are both a little risk adverse after I watched nearly a years worth of IRA gains wiped out. Monthly contributions are still being made but the market overall is making very little sense as it jumps up and down with little regard to fundamentals and her and I would both rather not drop large chunks until the volatility lessens. Sometimes sitting out a little while does work on the short term when things are just weird and fundamentals are ignored.

Some things can be timed though. People including my girlfriend thought I was an idiot when I told her to wait and rent for a year after moving to a new area. The popular consensus is that buying a home is always a win-win situation but with the $700+ a month she saved renting the same house model in the same neighborhood she has paid off all her bills except her truck, started really saving/investing, and has a start to a down payment on a new home. Meanwhile homes in her neighborhood are down an average of $40-70k depending on the model and there are tons of homes on the MLS and FSBO that have been sitting since the summer. The fundamentals for the area simply did not support the prices they were going for and they are still going down. With some illiquid purchases timing is everything.

[Matt]

The boyfriend is minimizing his returns. If you're going to try to time the market, what you should be trying to do is BUY LOW and SELL HIGH. He's doing the opposite. Dollar-cost averaging is the best strategy for those who don't want to devote themselves full-time to making investment decisions.