Don't Try to Time the Market: Do This Instead

It might be tempting to try to time the market, but there's plenty of research that shows it's just not worth it to play that game.

In this clip from Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann talk about a few things that long-term investors can do instead to reel in great profits from their investment, with much less of the risk and worry that comes with a market-timing strategy. They'll explain what dollar-cost averaging is -- and how it can work for you; why it's important to maintain a cash position in your portfolio; why it's so good for individual investors to buy into individual companies; how to pick which companies to invest in; and much more.

Dylan 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.

David 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 [to] 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% or 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.

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 -- 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." If you can diversify over time and ease into the positions in your portfolio over time, 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, [or] 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.