The dangers of trying to time the market
When uneasy investors see markets drop often they try to prevent losing more money by selling down their investments as quickly as possible; but this impulsive reaction can in fact do more harm to your potential return.
The picture below shows how investors might react when a drop in the market occurs:
The buyers in this example generally tend to be investors who believe they are on to a good thing, often not realising that they’re buying in at the top of the market when prices are high, and then selling when the market is at its lowest. The winners in these scenarios are the investors who take the opposite approach; i.e. they sell when they predict the market’s getting overpriced and buy when the markets are cheap. The result being that they make a profit. This is what active fund managers aim to do for you when you invest in a managed fund.
So, trying to “time” the market could mean that you miss out on growth in your investment when the market goes back up again.
If you maintain a regular investment regime over a sustained period of time, short-term drops in the markets won’t have as much impact on your overall investments. So instead of worrying about when to buy and/or sell based on market conditions, keeping to a regular savings/investment strategy will help to smooth the journey.
One technique that can be used to achieve this is known as Dollar cost averaging. This is a strategy where someone invests a fixed amount into an investment regularly (say fortnightly or monthly etc.) regardless of whether markets are moving up or down. So, for example, if you’re buying shares when prices are rising then you will purchase fewer shares than if you were buying shares when the price is lower.
Let’s look at an example of how that works: Let’s assume an investor decides to purchase $1,000 worth of XYZ Company Ltd shares at the same time every month for four months. In this example, we’ll also assume that the shares first decline in value, but then rally strongly.
Here’s what we learn from this:
- Using a dollar cost averaging strategy, the investor would have purchased 272.22 shares for a total of $4,000;
- The average price per share for this period would have been just $14.69 (calculated as follows: $4000/ 272.22 = $14.69);
- With the stock ending at $18 at the end of this period, the investor’s total position would now be worth $4,900 (calculated as follows: 272.22 shares * $18 = $4,900). As a result, the investor would actually have made a profit of $900, despite the fact that the share price declined in value over the full four-month time period (dropping from $20 to $18).
By comparison, if the investor had decided to invest $4,000 in shares of XYZ Company Ltd all at once at the beginning of this period, then they would have purchased 200 shares at a price of $20 per share. With the share price finishing at $18 at the end of the four months, the investor would have lost $400 on the value of the shares purchased.
So why does this matter?
Millions of investors around the world use dollar cost averaging because it offers the following benefits:
- It’s an attractive option for investors who want to contribute to their investment portfolios on a regular basis;
- It eliminates the issue of market timing. An investor’s returns will be determined more by the overall trend of the market as opposed to a specific entry (or exit) price.
- In addition, it can help to reduce the cost of buying investments that are declining in value.
So, if you’re looking to smooth out the ride, then investing regularly can help to make that happen.
(Excerpt taken from AMP article ‘What to do when Investment Markets fall’.)