Playing The Percentages When Investing

March 22, 2013 Current Commentary Comments Off
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Last week I bemoaned the self-defeating behavior of investors who become confident enough to buy stocks only after the price has gone up and who sell their shares in panic if there is a steep market decline.

The goal is to buy low and sell high, not the other way around. Stocks have a well-established track record of gaining value and beating inflation in the long run, which makes diversified buy-and-hold long-term investing nearly foolproof. Yet because we are humans, ruled at least as much by emotions as by logic, a large share of investors never benefit from the market’s performance.

With stock averages hovering near record highs, is this the perfect time to buy stocks? Obviously not. The best time recently would have been four years ago, when the market indices were around half of today’s levels. A well-diversified investment at that time would likely have doubled by now.

Yet I advised against waiting for another big downturn, because market timing is usually unsuccessful. Most stocks do not appear to be grossly overpriced, even at today’s levels, and it is unlikely that the next record high will be the high-water mark for all time. In the long run, even an investment at today’s higher prices is likely to gain value – just not as much value as if you had made it earlier, when stocks were cheaper.

A reader responding to last week’s article raised an excellent question and inspired this follow-up post. “Completely agree, but would have expected commentary about ongoing periodic investment of fixed amount for time weighted average investing,” my longtime friend Larry Anker observed.

The approach Larry inquired about is also known as “dollar-cost averaging.” It is a valuable technique when used appropriately. When it is used in the wrong situation, it can cost you money.

Let’s rephrase the question this way: “If I receive a large sum of money today, and I want to put it in the stock market, should I invest all at once at today’s prices, or should I chop it into installments, and put it into the market slowly, so I can benefit if prices go down?”

We can approach this situation the way a pair of baseball managers might, in the late innings of a tight game. With a runner in scoring position and a right-handed pitcher on the mound, the manager of the team that is batting will often remove his next hitter – who has a pretty good average, but who bats right-handed – and send up a lefty pinch-hitter instead.

The manager of the team on the field could counter by calling the bullpen for a left-handed relief pitcher. At which point, the manager of the batting team will sometimes send forth a pinch-hitter for his pinch-hitter, to match up a righty bat against the lefty pitcher. (This is where the cat-and-mouse game ends, because baseball rules require the relief pitcher to face at least one batter.)

Why do they make all these maneuvers? Because, on average, batters do better against pitchers who throw with the opposite hand while, conversely, pitchers are more effective against batters who stand on the side of the plate from which they throw.

The original right-handed hitter might still have gotten a hit against the starting pitcher, of course. Neither manager has any guarantee that his maneuvers will work. In fact, one of these two managers is guaranteed to be unsuccessful. Either the pinch-hitter will come through, defeating the strategy of the fielding team’s boss, or the relief pitcher will retire the batter he faces, frustrating the hitting team’s chief.

But both managers are playing the percentages. They try to maximize the odds in their favor. The fielding team might bring in a relief pitcher only to find him facing a batter on the opposite side of the plate anyway, but at least they will have forced the other team to use up two batters who were on the bench. That can help, later in the game.

When we invest in stocks, we know that more often than not, share prices go up rather than down. This happens at very high percentages over extended periods of time, such as a decade or two. It happens around 85 percent of the time when we look at a five-year time horizon. It happens, on average, about two times out of every three when we consider a one-year period. Often, the big up and down moves occur in very concentrated periods of just a few weeks or months, followed by long periods of seemingly random fluctuations. But there is a general upward trend, over time.

What does this mean for an investor holding a large wad of cash, wishing he had received the money a few years ago, before the stock market’s big rally?

It means that if you invest this money gradually, it is more likely that the approach will have you buying stocks at higher prices than if you put all the money in the market today. The market goes up more often than it goes down. That’s true even when the market has already gone up, as is the case right now. If it happens that the market drops during the coming year, a go-slow strategy might work out, but if you want to boost your odds of success, you won’t wait to invest.

Dollar-cost averaging, as I mentioned, can sometimes be very useful. I use it myself, but not for investing lump sums. I use it when I want to accumulate money over long periods of time, such as when building a college fund for a young relative.

To do this, I have my bank automatically send the same dollar amount to the investment fund every month. The fund puts a predetermined percentage (set by me) of the money in stocks – 100 percent until the youngster approaches middle school, and then gradually declining as we approach the point when we will want to draw on the fund. Once I set up the pattern, I don’t have to think about it.

Not thinking about it is a good thing. I’m not tempted to skip an investment at moments when the market is behaving as though the world is about to end. Those moments are, in hindsight, almost always the optimum times to invest. I’m not tempted to increase my investment amount when everything looks rosy on Wall Street, which is usually when the market has the farthest to fall. I don’t forget to make investments until some major market news either inspires me to pull out my checkbook or to run for cover. Because I invest the same amount every month, I automatically buy more shares when prices are low and fewer when prices are high, which holds down the average cost of my shares.

This slow-and-steady approach has earned a good reputation for dollar-cost averaging, which is why some knowledgeable people are prone to misuse it when it comes to investing a lump sum. Sometimes stretching out a lump-sum investment happens to work out. But it isn’t the course most managers would choose if they wanted to stack the odds in their favor.


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