“Running away will never make you free.”
“If you hold a cat by the tail you learn things you cannot learn any other way.”
Very recently, the S&P 500 surpassed a new high. Of course, in between the time this article is published and you read it, there may be a few more new highs.
I have clients who got out of the Great Recession and never put their money back into the market because they were afraid that they were going to invest right at the top of the market.
PK at Don’t Quit Your Day Job does an excellent job of covering investing during market lows, citing an investor who dollar cost averaged from the peak of the NASDAQ in March, 2000.
However, I wanted to take this question a little further.
Those of you who read “Value Cost Averaging or Dollar Cost Averaging?” know I am a fan of value cost averaging.
If you don’t know what value cost averaging is, go read that article and then come back. I’ll be here. Click on the link, and it’ll open in a new tab or window so that you don’t lose this one. How convenient! ☺
Since I have clients who were playing in the markets themselves rather than living by a steady, structured plan back in October 11, 2007 – the S&P 500 high that was recently eclipsed in March, 2014 – given that I was building the best big data and Solr software company out there prior to my financial planning endeavors, I wanted to look at four scenarios for people who were investing (or not) in the markets on that date.
Peak to Peak Investing, or, How Generally Not to Lose Your Shirt
Before we get going on this analysis, let me remind you of one thing.
Past performance is not indicative of future returns. What may have worked in the past might not work in the future. I can’t guarantee anything except that trying to watch the markets all day every day will cause you stress.
Our intrepid but uncertain investor has four different choices for how to invest his or her money.
- Pull out of the market and do nothing.
- Stick it all in at once in a lump sum.
- Dollar cost average.
- Value cost average.
To replicate investing in the S&P 500, I have used the returns of the Vanguard 500 Index fund (VFINX) from October 11, 2007 until March 7, 2014.
Variation 1: Take the money out and do nothing
This one is easy. The return on investment is 0%. Actually, it’ll probably be more like .5% since it’s probably in a CD or a money market account.
Good luck beating inflation!
Variation 2: Lump sum investing
For the next three variations, since there were 77 months between the start and the finish, I used $7,700 as the investment total.
In this case, I looked at investing a lump sum of $7,700.
If our person invested a lump sum at the last peak, once you include reinvested dividends, the return is 38.3%. That’s an annualized return of 5.2%.
But, the person could have also picked a random day to invest. How often would random timing beat systematic investing (variations 3 and 4)?
42.3% of the time, picking a random day would have beaten dollar cost averaging, and 16.5% of the time, it would have beaten value cost averaging. Based on this evidence, market timing does not work!
So, let’s look at more systematic approaches.
Variation #3: Dollar Cost Averaging
In this scenario, we had our investor invest $100 per month on the 11th of the month. If the 11th fell on a weekend, the investment went in the next business day.
Our investor put in $7,700 total, and, as of March 7, 2014, his value was $12,532.43.
That’s a 62.8% total return, or a 7.9% annualized return.
Variation #4: Value Cost Averaging
In this scenario, we had our investor either buy or sell to reach a target value. Each month, we increased the target value by $100, and had the investor either buy or sell enough of the fund to achieve that target number.
The difference between value cost averaging and dollar cost averaging was that the amount invested each month was variable.
Our investor put in a total of $4,143.13 and had a total value of $7,962.60 (portending a sale on March 11, 2014). That is a 92.2% total return, or a 10.7% annualized return.
But, there were times when the investor had to put in more money. At one point, he invested $605.32 in a month.
He also has $4,569.83 less overall than by dollar cost averaging. His rate of return was higher, but his total return was lower.
To potentially compensate, I added in an expected return. Since the compound average growth rate of the S&P 500 from 1871 through 2013 is 9.07%, I had the investor add in a monthly return (0.726% per month) to the expected return.
The value cost average investor then invested a total of $5,852.21 and had $10,618.27 at the end, for an 81.4% return, or a 9.7% annualized return. He invested a maximum of $736.89 in a month.
The reason that this return is lower is because this approach combines value cost averaging (for the $100) and dollar cost averaging (for the monthly return). The marginal return on the incremental dollars invested in this method, as opposed to simply increasing the monthly total from $100 to a higher number, was 7.1%.
Even in hitting a peak, investors on October 11, 2007 should not have stopped investing.
While dollar cost averaging forces you to invest more in the market over time than value cost averaging does, it comes at a cost – a lower return percentage. Value cost averaging gets you the highest return percentage, but pulls money out of the market over time. It may also force you to invest more in a given month than you’re ready to invest, but if you have the room in your budget, a better approach would be to value cost average more than you would if you dollar cost averaged. You will put more money to work in the market and get a higher return, giving you, ideally (remember, I can’t promise you any returns) a higher overall return as well as return on investment.
What about you? Have you ever been gun shy because you thought the market was at a peak? Let’s talk about it in the comments below!