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Finding the Best Time to Invest

As mentioned in a recent article, fellow blogger The Finance Buff has been running an experiment with his IRA contributions for the last two years. Here’s how he explains the experiment:

“Instead of contributing $5,000 at the first opportunity [$5,500 for 2013], I would wait for a small dip because prices almost always go down during the year.

Being chicken little, I didn’t want to wait too long. So I set my limit at 2%. I took a note of the closing price that I would’ve got had I done what I always did in previous years: go all-in on day one. I set an alert based on that closing price minus 2%. If I could get in at a price 2% lower than I otherwise would have, I would be satisfied and call it a day.”

I bring this up because I often receive emails about assorted variations on this type of strategy (i.e., strategies that wait for some specific signal to buy, instead of buying as soon as possible).

Relative to other strategies that attempt to beat the market, these strategies have one big advantage: They’re unlikely to increase costs in any way. (In contrast, many market timing or stock selection strategies result in more frequent transactions, thereby increasing trading costs and taxes. And strategies based on the use of actively managed funds increase costs via expense ratios.)

Because these wait-until-[something]-to-buy strategies shouldn’t increase costs, whether or not they’re a good idea is simply a question of whether the purchase timing indicated by the signal is better or worse than buying as soon as you have the money available.

Is a High Probability of Winning Good Enough?

Given the inherent volatility of the stock market, a 2% decline isn’t very much. Such a decline is likely to happen at some point in most years. In other words, The Finance Buff’s version of the strategy has a high probability of success in any given year.

But, in itself, that doesn’t necessarily make the strategy a good idea.

By way of analogy, consider a game in which you roll a 6-sided die. If you roll a 1, 2, 3, 4, or 5, I give you $1. But if you roll a 6, you have to give me $10. This is obviously not a good game for you, despite the fact that you have a high probability of winning money on any given roll.

In the case of TFB’s strategy:

  • A “win” results in an additional one-time return of roughly 2% (due to having purchased at a 2%-lower price), and
  • A “loss” happens when the market marches steadily upward all year, such that the buy-signal never occurs at any point, so the cost of a loss is missing out on a year of good returns.

So, how can we determine whether the probability-weighted gains from the “wins” are likely to exceed the probability-weighted cost of the “losses”?

Reducing the Number of Days In the Market

The primary attribute of wait-for-a-buy-signal strategies is that, relative to investing the money as soon as it’s available, they reduce the number of days that you’re in the market. (For example, in TFB’s version of the strategy, the excluded period is, “days in each calendar year prior to the first decline of 2% from the year’s starting price.”)  So the relevant question is whether or not the days that you are out of the market have a positive or negative expected return.

Of course, in general, the stock market has a positive expected return. Therefore, for the strategy to work over the long-term, it must be excluding days that are unusual in some way. That is, it must reliably exclude days that have not only below-average returns, but below-zero returns.

If you cannot think of a convincing reason why the particular group of excluded days would have a negative expected return, it doesn’t make any sense to use the strategy. Instead, you would want to invest your money as soon as it’s available to invest.

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  1. Thanks Mike. TFB could do OK with this, but I agree with your conclusion. Speaking from my own experience, I played with various “deferred” investing strategies over the years, including dollar-cost averaging of a lump sum into the market, a widely accepted practice. But I ultimately decided it’s not worth the mental or logistical effort. It’s generally better, in my opinion, to put the money to work as soon as you’ve got it.

  2. He who hesitates could be lost!

    The stock market often moves suddenly, and in BIG moves, both plus and minus moves.

    There is also the danger that you could be tempted to spend some or all of that cash.

    The biggest danger could be that you will freeze and never get into the market.

    Look at your asset allocation and see if you are in need of rebalancing. If not, contribute the money right away according to the asset allocation in your written Investment Policy Statement.

    Lastly, know in advance, the market WILL eventually go lower, possibly even much lower than the prices you paid. Don’t pay any attention to this short term noise! Stay the course for the long term. Keep focused on things you can control like costs and asset allocation.

    Due to a growing population and an expanding economy [yes! eventually, even after the Great Depression!] the stock market’s return has a long-term positive slope.

    In the Summer of 2008 I worried about this kind of move a LOT, as we performed a rollover of my wife’s retirement accounts from AIG to TIAA-CREF and at the same time made a re-allocation, with more going into Equity and Bond Index funds and less into a Stable Value Account. It made for an interesting Fall and early Spring, but we stuck to our plan, did not sell, and continued to dollar-cost-average into all our accounts. After taking some serious losses in 2008-9 we were well situated for the sharp market recovery over the past four years.

    I have no doubt that we will see lots of market ups and downs before our investing days are through. Growing up in the 1950s and 1960s we were taught in school that a crisis like the Great Depression could no longer happen. Now, we hear about “Black Swans”. Nodody knows the future!

  3. Mike, thank you for bringing it up here. I want to make clear a few things. First it’s an experiment with my own money, not a suggestion for anyone else to follow. The amount represents a very small percentage of my investments. Even the famous “dare to be dull”(R) investor Allan Roth has a gambling portfolio. Second I would be very happy to see this experiment lose. Because when that happens it means the rest of my portfolio is going up and up. It will also be a teachable moment proving that frequent smaller wins will not offset an infrequent larger loss.

  4. Hi Harry.

    Thank you for taking the time to reply.

  5. harry campbell says

    What would be wrong with this strategy? If the market goes up, you instantly buy. IF the market goes down, you wait and see if it goes below 2% dip and then buy? You haven’t lost anything if the market goes up since you put in a limit order to buy, but maybe it’s unlikely that the market will go down 2% from any one point without ever fluctuating first into positive territory.

  6. Hi Mike (and Harry),
    The problem with this strategy is the few times that the market (or stock) doesn’t drop 2% during the year, you’re frozen out of the market. If you don’t have a “give up, and buy back in” time, you could be out for the rest of your investing life.

    You’ll win your 2% most of the time. If you decide to give up at the end of the year, you’ll lose whatever that year’s gain is, which will probably be more than the market average of 9% or 10% in a year. If it didn’t drop even 2% its probably a pretty bull market for the year and you could have missed out on 20% or 30% (pays for a lot of 2% wins). If you don’t have a “give up” time, you could miss out on a lifetime of market gains on that money which could be hundreds of times your 2% “win”.

    Just eye-balling the chart on TFB’s page, it looked like the market didn’t drop the 2% on between 15 and 20 of the years in the 60 years since 1951. I don’t think the “expected value” math works for you.

  7. Robber Baron says

    And any ex-div dates you miss waiting for that decline.
    Average dividend payout ~2%, paid quarterly.
    So, in big thinking, 3 months cost 0.5%, and 1 month costs 0.1667% ? (plus compounding)

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