Avoiding timing traps with long term index investing

Question

Question

1) What are the risks pertaining to timing on long term index investments?

2) How large are these risks?

3) In case I feel not prepared to take these risks, how can I avoid them?

Background information

• Age 29
• Currently I do not own any bonds or stocks
• After selling my house I will have about one year income available for long-term index investing. If I put this money all at once in the market, than that would be timing.
• My plan is to invest 70/30 in stocks/bonds
• Each year I expect to invest about one quarter of my income
• I am located in Europe now. After selling my house I will move to Japan for a few years.
• Yes, I will make sure to keep some money for hard times on a savings account

My ideas

My guess is that, even if the stock market drops enormously over the next few years, this will not have such a big impact on the end result in say 30 years. I fear more the emotional impact that a new crisis, eating up a large part of the money that is now in my house, might have. The temptation of withdrawing from such a market might be hard to resist, while the rational response would be to stay and keep investing.

P.S Here is another question on timing related to long index investments

When is the best time to put a large amount of assets in the stock market?

Answer 1

1) The risks are that you investing in financial markets and therefore should be prepared for volatility in the value of your holdings.

2) You should only ever invest in financial markets with capital that you can reasonably afford to put aside and not touch for 5-10 years (as an investor not a trader). Even then you should be prepared to write this capital off completely. No one can offer you a guarantee of what will happen in the future, only speculation from what has happened in the past.

3) Don't invest. It is simple. Keep your money in cash. However this is not without its risks. Interest rates rarely keep up with inflation so the spending power of cash investments quickly diminishes in real terms over time.

So what to do? Extended your time horizon as you have mentioned to say 30 years, reinvest all dividends as these have been proven to make up the bulk of long term returns and drip feed your money into these markets over time. This will benefit you from what is known in as 'dollar cost averaging' and will negate the need for you to time the market.

Answer 2

What are the risks pertaining to timing on long term index investments?

The risks are countless for any investment strategy. If you invest in US stocks, and prices revert to the long term cyclically adjusted average, you will lose a lot of money. If you invest in cash, inflation may outpace interest rates and you will lose money. If you invest in gold, the price might go down and you will lose money. It's best to study history and make a reasonable decision (i.e. invest in stocks).

Here are long term returns by asset class, computed by Jeremy Siegel:

$1 invested in equities in 1801 equals $15.22 today if was not invested and $8.8 million if it was invested in stocks. This is the 'magic of compound interest' and cash / bonds have not been nearly as magical as stocks historically.

2) How large are these risks?

The following chart shows the largest drawdowns (decreases in the value of an asset) since 1970 (source):

Asset prices decrease in value frequently. Financial assets are volatile, but historically, they have increased over time, enabling investors to earn compounded returns (exponential growth of money is how to get rich). I personally view drawdowns as an excellent time to buy - it's like going on a shopping spree when everything in the store is discounted.

3) In case I feel not prepared to take these risks, how can I avoid them?

The optimal asset allocation depends on the ability to take risk and your tolerance for risk. You are young and have a long investment horizon, so if stocks go down, you will have plenty of time to wait for them to go back up (if you're smart, you'll buy more stocks when they go down because they're cheap), so your ability to bear risk is high. From your description, it seems like you have a low risk tolerance (despite a high ability to be exposed to risk). Here's the return of various asset classes and how the average investor has fared over the last 20 years (source):

Get educated (read Common Sense on Mutual Funds, A Random Walk Down Wall Street, etc.) and don't be average!

Closing words:

Investing in a globally diversified portfolio with a dollar cost averaging strategy is the best strategy for most investors. For investors that are unable to stay rational when markets are volatile (i.e. the investor uncontrollably sells their stocks when stocks decrease 20%), a more conservative asset allocation is recommended. Due to the nature of compounded interest, a conservative portfolio is likely to have a much lower future value.

Answer 3

It's amusing that despite all the evidence that "you can't time the market", everyone still wants to try. Of course I understand your fear. If you invest all your money in the stock market today and it suddenly falls tomorrow you will feel very bad. There are a few things you can do to reduce your risk with respect to timing, however:

• Don't plop all your money down on the same day. Invest in the market over time, perhaps a few hundred dollars per month worth (depending on your appetite). This averages your purchase cost to ensure you aren't buying at the time when prices are highest. The down side is of course that if you leave cash sitting around, you might also not be buying when the prices are lowest either and will probably miss out on some gains. Still, if risk is your concern, this is a sound strategy.

• Invest in various markets overseas. This will expose you to some currency risk, but lower your timing risk, as even with globalization markets don't rise and fall in tandem.

Even with both of the above, you can still be just plain unlucky (or lucky). I would recommend that you invest only money that you don't need to take out in the near future (in order to reduce the chance that the money will have lost value since you put it in!), and that you don't watch the markets since it makes a lot of people nervous and tends to prod them into doing exactly the wrong thing at exactly the wrong time.