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Is now a good time to invest?

Trying to decide if now is a good time to invest? Whether you’re a passive investor looking to understand market cycles or an active investor who wants to time the market, this article will explain how often stock market prices rise and fall and why, so you can make an informed investment decision about when to buy stocks.

Is market timing a good idea for long-term investing?

Trying to ‘time the market’ means considering when to make an investment during bull markets​ and attempting to sell before or during down periods to possibly reduce losses.

If you’re investing for the long-term, it may be better to invest and continually add to positions – each month or at set time intervals – as opposed to trying to time the market. A buy and hold strategy has produced an average annual return of 10.3% between 1957 and the end of 2020 for the S&P 500, according to data by DQYDJ. This return assumes dividend reinvestment.

The US stock market has historically risen much of the time, which means trying to time it may not be such a good idea. According to Morningstar, between 1926 and 2019, the stock market rose 100% of the time over a 15-year period and rose 87% of the time over a five-year period. Stocks prices rose on a yearly basis 73% of the time.

Simply investing and holding a diversified basket of stocks or index funds for a long period of time tends to produce a profit. When trying to time the market through buying and selling, the above statistics no longer apply, and it is quite possible investors could do worse.

Bear markets​ are generally short-lived, whereas bull markets tend to last much longer. By investing in and out of the stock market, it is quite possible to miss part of the good times since they occur more often. If the best month of the year is missed, returns for a given year are generally cut dramatically. Since most investors are unlikely to know what month of the year will be the best, it pays to stay invested. Not being invested during the good months could be more detrimental to long-term returns than trying to avoid the fewer down months.

Essentially, the market moves higher more often than it moves down. This means, for most investors, if they exit the market, they are more likely to miss out on profit, as opposed to avoiding a loss.

It may not be in every investor’s interest to try to time the market. The exception would be if an investor has a tested method/strategy that has outperformed buy-and-hold. They must not only know the strategy but have the conviction, time, and discipline to implement the strategy the entire time they are investing. As discussed above, even missing out on a few good periods (which occur more often than drops) will reduce performance.

As investors, there is always a risk when making financial decisions, as we can’t be sure that past performance will be indicative of future performance.

Diversification’s role in reducing volatility

Portfolio diversification​ is when you invest in multiple stocks and assets, as opposed to investing in only one or a few stocks. Diversification reduces volatility in a portfolio, as the more stocks that are held, the less impact any single stock has. If an investor owns one stock, and it goes bankrupt, the portfolio goes to zero. If the investor owns 100 stocks, with 1% of their capital in each, then if one stock goes to zero, the portfolio only loses 1% based on that event.

According to Morningstar, the average market crash​ or sell-off in the US has seen a downside of between 20% and 30% and tends to recover quite quickly — apart from the Great Depression in the 1930s. However, if you’re investing in only a few stocks, the down periods could be much more severe and long-lasting. Instead of trying to time the market, consider putting that effort into creating a diversified portfolio that will weather downturns and volatility well.

Passive investing for the long term

Passive investing is buying stock index funds, or a selection of stocks, and holding onto them for the long term. Regular contributions may occur, but the investment is not sold until retirement or until the funds are needed.

The approach can be automated, requires very little research and no market timing. The positions are not traded in and out of. Passive investing is the opposite of market timing. Market timers are interested in getting out before declines and trying to buy the dip to get advantageous prices before the next rally.

Passive investors are more concerned with dollar-cost averaging, which is making regular contributions so that the price paid evens out over time. Sometimes a high price is paid, but other times it’s a low price. Overall, the investor gets an average price over many purchases, which negates any good or poor purchases. No single purchase price matters. The investor benefits from the long-term rise of the stock market without the wasted effort of trying to buy at the perfect time.

When looking at the past performance of the stock market, such as a 10.3% yearly average return for the S&P 500, that is a passive investment return. All an investor had to do was hold an index fund or index ETF to achieve those returns.

Index funds or index ETFs track stock market indices. Buying one of these funds provides exposure to potentially thousands of stocks with a single transaction. Investors may buy or make regular contributions to one index fund or several. These may include domestic or foreign stock indexes, as holding different types of indexes in a portfolio increases diversification.

Day trading vs investing

Day trading​ is the opposite of investing, especially passive investing. Day traders make multiple trades each day, attempting to capture small price moves, often with large position sizes. Investors, on the other hand, typically invest a very small amount in any given share they own (each index holds many different stocks) and want to capture the long-term upside of that stock, not the minute-by-minute fluctuations. Some investors may also choose to try and outperform the market by picking stocks, so read our guide on 13 different strategies for picking stocks​.

Day traders have a short-term time horizon, while investors have a long-term time horizon. Their risk tolerance is also different. Investors generally try to reduce volatility through diversification. Day traders often seek out volatility because lots of movement – either up or down – means they can jump in and potentially capture a small piece of the move. The bigger the price moves, potentially the bigger the piece they can grab. Day traders will be more focused on trying to time the market to try and achieve market beating performance.

Things to watch out for if you do want to try timing the market

There are valid arguments against trying to time the market, but if an investor can time the market – capturing most of the good times while avoiding some of the bad times – there is potential to make higher-than-average returns.

For those seeking potentially higher returns or that have a shorter time horizon (and don’t want to buy and hold for the long-term), here are some things to watch for when trying to time the market.

Valuations

Stock valuations provide insight into whether stocks are over-priced or underpriced relative to historical standards. With an overvalued stock, an investor may take it as a signal to begin selling off their positions. With an undervalued stock, they may consider accumulating positions.

A popular valuation metric is the price/earnings ratio​. Historically, the P/E ratio for the S&P 500 has averaged about 15, meaning stocks trade at a price that is 15 times their yearly earnings, according to data on Multpl.com.

When a P/E ratio is near or below 10, that means stocks are priced quite low by historical standards, and it may be a good time to buy. When stocks are priced above 20, they may be overvalued, and it may be a good time to sell. However, this will vary depending on the industry.

Unfortunately, this valuation method has become more complex since 2008 with the introduction of quantitative easing​ and very low-interest rates. Since 2000, P/E ratios have remained elevated. Yet, there were plenty of very good periods to be invested, including most of the period from 2010 to 2021. That said, P/E valuations are still useful and provide a perspective on how elevated or undervalued stock prices are.

Monetary policy

Monetary policy​ is how governments and central banks manage the economy through money supply and interest rates. As mentioned above, starting in 2008, in response to the financial crisis, many governments around the world adopted quantitative easing, which is essentially injecting cash into the financial system. This process has continued into 2021 and potentially beyond. It is also coupled with low-interest rates.

Low-interest rates and money being pushed into the financial system is generally a good thing for stocks. More money supply means more money to buy stocks with, which pushes prices up. Low-interest rates mean it is easy to borrow funds at a low cost, which helps the economy and expands business, and that is good for the stock market.

Because of quantitative easing, valuations have remained high, which may be one of the reasons why the US stock market performed well between 2010 and 2021. Low interest rates and a high money supply help push stock prices up.

The flip side is that if the money supply shrinks and/or interest rates increase, these generally have a negative effect on stock prices. Therefore, market timers can watch monetary policy to aid them in their investment decisions.

Market sentiment

Market sentiment​ refers to how bullish and bearish investors are, as a group, about the stock market. Extreme sentiment can often signal buying and selling opportunities.

When sentiment is overly high, relative to the sentiment indicator’s historical values, that may indicate the stock market is due for a decline. If sentiment is overly low, the stock market may be due for a rally.

The reasoning is that if most people agree on the direction of the market, who is left to keep pushing the market in that direction? Very few people, which means the price direction will generally reverse.

A popular sentiment indicator is the CNN Fear & Greed index, which measures a total of seven sentiment indicators. A reading over 80, and especially 90, signals the market is getting euphoric and may be due for a correction. Readings below 20, and especially below 15, are generally bullish.

FAQs

Does market timing work?

It can. However, the investor needs a sound strategy that determines when they get into the market and when they get out. The strategy should be backtested​ over many years to verify that it can outperform a buy-and-hold strategy. Market timing requires much more research and time investment than a passive approach but has the potential to produce higher returns.

What does Warren Buffett say about timing the market?

The celebrated long-term investor, Warren Buffet, warns people against trying to time the stock market. Instead, he recommends that investors buy low-cost stock index funds, and hold onto them, benefiting from the long-term rise of the stock market.


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