Most individual investors build their portfolios gradually over time, often investing a portion of each paycheck.
You might not associate a name with it, but making gradual, routine investments over time is a strategy known as dollar-cost averaging. It feels good to invest when stock prices keep going up, but stick around the stock market long enough, and the pendulum will swing the other way.
Stock prices do go down, and bear markets occur when the market declines 20% or more from its high. It's not fun, but it's normal. But bear markets can evoke negative emotions, such as fear and stress, and may prompt people to stop buying or sell and withdraw from the market altogether.
But what happens if you stay the course, endure the pain, and keep investing through bear markets? Here is what history says.
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Why bear markets can feel so frightening
The stock market cycles between bull markets and bear markets.
Historical data for the S&P 500 index (^GSPC -0.22%) says that the typical bull market is approximately 3.5 years long and gains over 100% returns on average. On the other hand, bear markets typically average a 35% decline from highs but last under 10 months.
People often have short memories and emphasize the most recent data. By the end of a bull market, it can feel like stocks only go up. The sudden and sharp decline of a bear market can be a shock to the system.
History shows investors are best to continue dollar-cost averaging through bear markets
Analysis of historical market declines demonstrates how dollar-cost averaging through them can minimize the damage and help your portfolio recover sooner.
The bear market following the dot-com bubble in the early 2000s was one of the worst downturns in recent history. Morningstar modeled how an investor who dollar-cost averaged into the S&P 500 would have fared from March 2000 to October 2022 compared to someone who made an initial lump sum investment.
The data showed that dollar-cost averaging limited losses to just 1.75%, while the lump-sum investor suffered annualized losses of 13.84% during that time.
The bear market during the 2008 financial crisis was another brutal stretch for investors. However, those who dollar-cost averaged recovered from it sooner. A Fidelity study determined that a hypothetical portfolio of 70% stocks and 30% bonds would have returned to its former highs in 52 months.
Importantly, those who sold their investments or withdrew from the market took longer to recover, or never did. That's why investors must try to avoid making fear-driven decisions with their money.
Does timing the market matter?
Remember that trying to anticipate stock market crashes is virtually impossible, no matter how many predictions or circumstantial evidence you find to support a prediction.
But suppose you had a crystal ball and could invest an entire year's worth of capital at the perfect time every year. Wouldn't you blow away someone who dollar-cost averages?
RBC Global Asset Management used data from Morningstar to find out. Their study analyzed what would happen if someone with a diversified portfolio invested $3,000 annually from 2005 to 2024:
- Investor 1 invested the entire $3,000 at the market's lowest point each year.
- Investor 2 dollar-cost averaged with monthly purchases.
- Investor 3 invested the entire $3,000 at the market's highest point each year.
- Investor 4 avoided the market entirely, saving their cash in an interest-bearing account.
Unsurprisingly, Investor 1 fared the best, ending with $148,959. However, Investor 2 ended with $137,328, a total difference of just 8.5% over the entire 20-year period. Even someone who bought at the worst possible moment every single year wound up with $128,847, far more than someone who didn't invest at all ($71,785).
The lesson?
The length of time you stay invested is the most significant factor in your long-term results. Even perfect timing barely outperforms dollar-cost averaging over the long term, and you may even perform worse trying to pick and choose when to invest.
Most people should stick to a simple, steady buying schedule, diversify their portfolio, and focus on consistency. That includes bear markets! Selling your investments or avoiding the stock market altogether can feel like the right thing to do during market downturns, but history shows it's probably not a good idea.
