Why Investors Shouldn't Try and Time the Market

The market is doing historically very well these days -- so well that many investors are wondering if maybe they should try and wait for the next correction before buying in.

On this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann explain why it's not a good idea to try and time the market, even when a correction seems imminent. Find out why so many of the most successful investors strongly urge against market timing, what dollar-cost averaging is and how investors can use it to diversify their investments across time, and much more.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 21, and we're talking about timing the market. I'm your host, Dylan Lewis, and I'm joined in studio by Motley Fool premium analyst David Kretzmann. David, how's it going? 

David Kretzmann: It's going well, it's a Friday so I can't complain.

Lewis: And we have a listener question to talk about. Those are my favorite episodes.

Kretzmann: Me too. It's a lot of fun and I'm excited to dive in!

Lewis: We got a question from Hunter, one of our listeners, a while back. It took a little time to get back to him, but I think the reward for taking time and waiting is, we'll wind up doing a podcast episode on it. So, sorry, Hunter, you're finally getting the answer that you asked for.

Kretzmann: We're coming around.

Lewis: He wrote into the show and asked, "The stock market seems to be highly overvalued. From what I last read, the long-term average of the P/E ratio of the S&P 500 has been about 15, and now it's over 26. Would now still be a good time to invest during this bull market, or would it be better to sit on some cash and wait for a while and hopefully see that market correction and invest then?" I love this question, and, broadly, I love getting listener questions. If someone out there is thinking something, chances are there are dozens or hundreds of Fools all thinking the same thing. Hunter, thanks for writing in. If other people have questions, [email protected]. Let's jump right into it, David. He's talking about market timing. I think this is something that's on a lot of people's minds. If you consume financial news at some point over the last year, you've probably seen something along the lines of, "The market is due for a huge correction," right?

Kretzmann: You're probably been hearing that since 2009, since the Great Recession. It is a common fear, especially when you've had a multiyear bull market, and you have stocks hitting fresh highs on what seems like a pretty regular basis. We haven't had many 10% sell-offs over the past seven years. It's a good question, and it's something to keep in mind as an investor. On average, the stock market declines about 10% every 11 months, or about every year. Then, you'll have a bigger 20%, 30% or more decline every three to five-plus years. As an investor, you want to expect the market to go down. That's just part of the price you pay as an investor to get historically above-average returns with the stock market. But, I'll take a contrarian point here, since we will be talking about some of the potentially bearish indicators. Going forward right now, the market looks historically a little pricey when you look at the P/E ratio of 26. As you mentioned, the historic ratio tends to fall a little closer to 15 or 16 or 17. The forward P/E ratio of the S&P 500 right now is 18. That means, based on what analysts are expecting, the S&P 500 is expected to earn over the next year, right now the market is priced at 18 times those forward earnings. That shows that expectations are pretty high that growth will continue for the companies in the index. That's one angle. On a forward basis, if these companies can continue to grow, maybe they can grow into the valuation, and you don't necessarily need a big sell-off to revert back to those historical averages. That's one angle.

A couple other things we're actually going to talk about on Motley Fool Money today as well, on our radio show, the housing market is still below its historical averages. The housing market has slowly but surely been recovering since the Great Recession. But housing starts, which basically means the construction of new homes, is still below the long-term averages going back to 1960. As millennials now, people between the age of 18 and 34 in the U.S., they're now the largest demographic in the U.S. ahead of baby boomers. As people our age, Dylan, start to get closer to 30, they're thinking, "Maybe I don't want to rent a house anymore, I want to buy a house or even build a house," that does a lot to spur growth within the economy, because there's so much that goes into the purchase and the upgrade on the renovation of a house. That's something that can drive economic growth and spending over the long term. Just a couple things there. Yes, on the surface level, the market does look pricier than normal. But there are some factors that make me think, it doesn't necessarily mean you're going to have a huge crash right away. That's not to say that's not going to happen. As I mentioned before, you want to be prepared as an investor for some sort of sell-off down the road.

Lewis: I think, to add to that, you look back over the last year and a half or so, and the market has navigated what I would say are two major shocks to the system, one of them being Brexit, and the other one being the election of Donald Trump. Two big surprises that the market really wasn't anticipating. And yet, it has weathered it and continued to grow at this really great rate. I will lay out the argument for why there's probably a correction coming at some point in the next decade to 20 years, and what the financial media narrative has been. For people that aren't familiar, basically, the gist of it is, because of quantitative easing, which is basically the Fed getting money into the economy, making borrowing very cheap, interest rates have been historically low. They've been historically low for a very long amount of time. Because of those low yields, investors have been pushed into equities because they're looking for better returns. That demand drives up stocks into overvalued territory. That's what we see, that's the gist of all of these research notes that are saying the market is overvalued. Really, that line of thinking totally makes sense to me. My college economics coming back, I totally see the dots connecting there. And Hunter brings up great points with the data here. Typically, the S&P 500 on a trailing basis, P/E somewhere between 10 and 20. 

The problem, though, is that even if you're right with what your thesis is, when it comes to market timing and deciding, "I'm going to wait three months to do anything," or, "I'm going to sell now because it seems like we're at peaks," is you have to be right not only about the thesis, but you have to be right but the timing and when you act on it, and it's really tough to nail both of those things.

Kretzmann: It's really tough. There are some interesting dynamics at play, and it's incredibly difficult to predict where the market is going in the short term. You have a lot of experts from the International Monetary Fund, the IMF, and high-ranking economists who were predicting before Brexit and the U.S. election that if Britain leaves the EU, and if Donald Trump is elected president, there's a very high likelihood that the market will crash. And lo and behold, the market is hitting new highs as a result. It's also interesting to look at what Warren Buffett has been doing. We traditionally see Buffett as more in that value mode as an investor. Between the U.S. election of Trump and early February, he was a net buyer of stocks. He bought over $20 billion of stocks, including Apple (NASDAQ: AAPL), which has been an incredible performer, and driving a good chunk of the returns of the S&P 500 this year. If a correction was coming, if a crash was coming, Buffett would be the last person I would expect to be buying stocks, because he tends to be a more conservative investor. To your point, Dylan, I think it's a great point, looking at interest rates. Interest rates are at historic lows. We haven't really navigated through prolonged periods of such low interest rates. When looking at investments, you have to look at the alternatives. If you're not going to invest in stocks right now, where are you going to invest? The U.S. Treasuries or bonds are yielding 2% to 3%, 10-Year Treasuries, which is very low. So, that's not very attractive. You could put it in your savings account, maybe 1%, if you're lucky, or less. So, you have to look at the alternatives. So, it's understandable to see why people are looking at the scope of investment possibilities right now. And they're gravitating toward stocks, even though, yeah, they look, on average, pricier than they typically have been. But compared to everything else, it still looks more attractive.

Lewis: Yeah. Bringing it back around to some historical examples, Hunter's question reminded me of news that was swirling in early 2016. I'm sure you remember this. There were several big banks, RBS (NYSE: RBS) was one, I think Morgan Stanley (NYSE: MS) was another, they put out research notes in January, and they were basically urging their clients to sell stocks. They were saying, "We see these cataclysmic issues coming to the market." It was, again, largely due to quantitative easing stuff with the Fed, low interest rate environments, and what that does to equities over an extended period of time, or else some growth concerns with China at the time. And you look at the run that the market has gone on since January 2016, I think it's up about 20%. I think a couple things that underpin why it's better to stay invested, even with the unpredictability of the market. There's a ton of volatility out there. Since 1928 -- this is a stat that I love -- the S&P 500 has lost 20% or more in six years -- 1930, 1931, 1937, 1974, 2002, and 2008. Aside from Great Depression years, in the following year of each 20% drop, the market has roared back with 25% or more return. So, the good and bad tend to follow each other very closely. 

If you look at things on an individual basis, as well, JPMorgan (NYSE: JPM) puts out this guide to retirement every year, it's kind of an overview of asset allocation, different strategies, and they also looked at the impact of staying fully invested versus missing certain days in the market. Over 1996 to 2015, missing the 40 best days in the market takes your returns negative if you had been invested in the S&P 500, and six of the ten best days for the market during that period were within two weeks of the ten worst days. So, individually picking and looking at these individual indicators can be really difficult, and oftentimes the market tends to flip very quickly. Again, getting to timing, it's really difficult to nail that down.

Kretzmann: Yeah. If you're hesitant to buy today, you have to figure out, what would make you a buyer of stocks? Would it be after a 10% drop? A 15% drop? A 30% drop? What are you waiting for to be a net buyer of stocks? And making that kind of timing decision is incredibly difficult. That's why you have great investors like Warren Buffett and Peter Lynch who say, "Do not do market timing, it's probably the worst thing you can do for your future returns as an investor." Often, psychologically, when the market is down 8%, you might think, "Oh, I'm just going to wait until it's down a little bit more, I'm going to wait for it to recover a little bit," and you get into these mind games where you're hurting your future returns, because making that timing decision of both when to buy and when to sell, it just raises the probability that you're going to mess up somewhere along the line. As you've outlined in a nice way, Dylan, the key is to be invested through the good and the bad times. I know later in the show, we'll talk about some different ways that you can invest in a way that you're still comfortable and you're sleeping well at night, which is what you should do. 

But the best thing you can do as an investor, the main advantages you have, here at the Fool, we believe, first, in, investing in individual companies. So, you have to factor that in. You're not necessarily buying an index fund, or buying a whole collection of companies. You're focusing on individual businesses. As an individual investor, your main advantages are, you can try to find and invest in and hold the greatest businesses out there -- the Apples, the Alphabets (NASDAQ: GOOG) (NASDAQ: GOOGL), the Facebooks (NASDAQ: FB), the Amazons (NASDAQ: AMZN), those kinds of companies -- and then you can also hold for a really long time. On Wall Street, the average holding period for a stock is now less than six months. Back in 1960, it was over eight years. The average holding period for a stock today is weeks or months. But, as an individual investor, you can say, "I'm just going to tune out that short-term noise. I want to invest in great businesses. I don't care about what's going to happen over the next year or two, I'm more interested in, what is Amazon or Facebook or Apple going to look like in 10 or 15 years, not what they're going to look like in the next year." So, as an investor, the best thing you can do is lengthen your holding period, or your time horizon. Our former Fool colleague Morgan Housel has done some incredible research on this, looking back at historical S&P 500 data going back to 1870. He found, if you had held a stock for one year, basically looking at every incremental one-year period going back to 1871, if you just held for one year, it's basically like flipping a coin. One year you will be up, one year you'll be down. It's flipping a coin, basically gambling, if you're just trying to predict where things are going to go where things are going to go over the next year. But if you lengthen that out to five years, 10 years, 20 years, the odds of you making money at the end of those longer holding periods increases each time. There's actually been no 20 year period that if you had bought and held the S&P 500 over 20 years where you lost money. That's after inflation. That includes the Great Depression, it includes the Great Recession. Really, the message there is, the No. 1 best thing you can do as an investor to guarantee higher returns is to lengthen your time horizon. 

Lewis: You talked about investing in individual companies. I think that's something that can get lost in the huge macro stories we see. Very often, will something that is a sweeping macro issue really impact a company like Facebook? The fundamentals that underlie the businesses that you're investing in probably aren't touched all that much by something like rising interest rates. Yes, it will at least be something that impacts of broad market, but they still have the user growth they have, they still have the base of advertisers that are happy to put stuff on their platform. So, you have to remember that you're investing in the individual business, and while it's scary that there might be some rumors circulating about cataclysmic stuff going on in the market, the fundamentals of that business are really what's underpinning your investment.

Kretzmann: Definitely. Within the Odyssey II portfolio in Supernova that I head up with a team of a few other Fools, I will admit that we are having a harder time finding glaring bargains with individual companies right now. Stocks are, for the most part, more expensive than they typically are. You get outside of your comfort level a little bit. But we're tasked every month with managing this real money portfolio, and we have to make a purchase every month. The approach we take there is just focusing on the individual businesses. We'll build up positions in companies over time. I think at a time like this, you want to build positions in companies that you'll be comfortable adding to if they go on sale 20%, if they go down 20% to 40%. So, maybe that's Amazon, maybe it's Alphabet. Whatever it is, companies that you feel pretty confident will be around over the next 10-15 years, companies that are generating strong cash flow, maybe they pay a dividend, maybe you start with a small position and then say, "You know what? I would actually really be happy if I could buy this company for a 30% discount, because I don't care where it'll be in a year or two. I'm more interested in the next five to 10 years or more."

Lewis: David, we talked about how market timing's hard, and I think that gives a lot of people this impression of, "What the heck am I supposed to do?" The market is rich right now, we just talked about that. What's our advice for investors here? We teased it a little bit in the first half. How do you go into these market conditions and think about placing money? You talked about the Odyssey portfolio little bit, obviously, you personally invested as well.

Kretzmann: Yeah. I would say, on a higher level, you want to invest in a way where you're sleeping well at night, you're focusing on the underlying businesses in your portfolio, assuming you're investing in individual stocks, which, you probably are, if you're listening to this show, you're focusing on the long term, and investing in such a way that you see a market drop as an opportunity and not something to fear. There are a few ways you can go about that. One of the easier ways is dollar-cost averaging, where you say, "Every month, I'm going to invest a set amount." This is especially easier if you're working in your life and have a regular stream of income that you are contributing every month or quarter to your portfolio. Say, "Granted, the market looks a little bit pricey now, but I'm going to invest a little bit every month, I'm not going to pay attention to the price too much, I'm just going to find companies that I really like, or maybe an index fund, and I'm just going to invest a little bit every month, every quarter, in some sort of increment that makes sense." Another approach that we use in Odyssey II is, maintain a cash position. For some people, that might be 10% of their portfolio. If you're really conservative and you recognize, "If the market goes down 40%  50%," which probably will happen about every decade or so. You should assume that will happen at some point. Maybe you want 40% of your portfolio in cash. And you're fine recognizing that "I might miss out on some of the upside, but I'll sleep a lot better at night, and I won't panic when the market drops." 

So, it's really just a matter of evaluating your own psychology and psyche as an investor. And you should probably assume you'll be more scared than you think you'll be. Because it's really easy when the market is going up to say, "Yeah, I got this. 10% drop? Bring it on." And then it happens and you're panicking, you're like, "Oh my gosh, I need to sell, I'm not going to buy." You really want to be cautious with your approach. You want to assume you'll be more scared than you think you'll be when the market drops. Go in with that assumption. But, build your portfolio around the understanding that market drops will happen, but invest in such a way that you won't let those drops get to you, that you'll continue to stay focused on the underlying businesses behind the stocks in your portfolio, because the long-term performance of those businesses is, in the end, what will drive the performance of those stocks. If a recession comes, or a market crash comes, it doesn't matter how great the business is, just about every stock is going to get hit a good amount. That's what happened in the Great Recession. You had great businesses like Starbucks (NASDAQ: SBUX) -- it's coffee, it's not going anywhere, but still the stock got hammered. Again, you want to invest in a way that you're focusing on the underlying businesses, the long-term performance of those businesses, staying focused on the long-term as an investor, and sleeping well at night.

Lewis: Yeah. I think, regardless of market conditions, it's always good to have a little cash on the side, because even in a raging bull market, if you have a stock you really love that reports iffy earnings because of some one-off charges or something like that and the market reacts poorly and shoots it down 7% or something, that might be a good buying opportunity. I know Kristine Harjes, the Healthcare host, did an episode a little while back about the importance of having a watch list, and some cash on the side so that as opportunities come up, you have the flexibility to act on them. I think that's definitely one thing to keep in mind. I think another thing with investing is, yes, it's a bull market right now, but when you're buying shares, I think a next-level investing type thing is, you're buying bits of shares. You don't want to buy your whole position in one transaction. You want to slowly build to the position you want. That gets at that dollar-cost averaging. If you want to eventually hold $3,000 of Facebook stock as currently valued, maybe you invest $1,000 now, $1,000 in a couple months, and $1,000 later in 2017 so that you get that nice blended average of cost, and you're less susceptible to one really high point in the market, and one really high point for Facebook stock.

Kretzmann: Yeah. Diversification is really key on a lot of different levels. First, you want to diversify your portfolio across different companies that you're comfortable with, you believe in for the long term. But what dollar-cost averaging does is it diversifies you across time. If someone started investing in late 2007, they have a pretty bad perception of the stock market, like, "This stinks, why does anyone do this?" On the other hand, if you started investing in March 2009, you're like, "Man the stock market is so awesome, this is so easy, this is shooting fish in a barrel." But, if you can diversify over time and ease into the positions in your portfolio over time, that way you have less risk as far as time exposure. We commonly think about diversification across the businesses or stocks in the portfolio, but you also want to think about diversification in terms of time, and dollar-cost averaging is definitely one way to do that.

Lewis: Yeah, I think that's a great point. Maybe we can't provide personal advice to Hunter, but I think someone in Hunter's position, where, maybe you're relatively new to investing, you have some cash you're interested in, maybe it's, slowly start to take bites, and get a better understanding of the businesses you're investing in, and maintain some cash position so that as there are deals that become available in the market because of minor dips here and there, you have the opportunity to continue to act on them.

Kretzmann: Definitely, yeah. Like I mentioned earlier, I know I've been repeating myself a lot in this episode but it's such a key point, you want to set up your portfolio in a way that you seen a drop as an opportunity, not something to fear, because the drops are inevitable. This bull market could continue for the next three years, we could have a 20% drop next month. No one knows. Again, even the experts got Brexit and the U.S. election totally wrong. And that was a consensus expert opinion, it wasn't controversial what they were predicting. Just assume, understand that a drop will come at some point. It could be next month, it could be five years from now. But invest in such a way that when that drop comes, you see it as an opportunity, and not a reason to succumb to fear.

Lewis: Yeah. I think that's a good point to end on. David, thanks for hopping on the show!

Kretzmann: Anytime, Dylan. Thanks for having me!

Lewis: Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say, "Hey," you can shoot us an email at [email protected]. Like I said, I love getting those questions for episodes. You can always tweet us @MFIndustryFocus, as well. If you're looking for more of our stuff, you can subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!