Most recently, we learned that we cannot time the market and we shouldn’t even try.
The numbers behind this are pretty uncontroversial, but a lot of people still believe that they are the exception. Even a significant number of people that believe you shouldn’t time the market still carve out little exceptions.
One of these is the practice of saving up cash and investing that extra money when the market drops. It makes sense – if you can invest more when the market is down, then you’ll earn more when it comes back up. I’ve read this advocated in the personal finance space quite a few times and I’ve even done it myself before.
But it is wrong.
Even this form of timing the market will lose you money.
Dollar Cost Averaging vs. Lump Sum Investing
Before understanding why this is, we need first to understand a related debate: Dollar Cost Averaging vs. Lump Sum Investing.
Dollar cost averaging is a fancy term for investing the same amount consistently.
If you invest in a 401(k), then you are dollar cost averaging. Your contribution is the same every paycheck and it goes into your account on payday. Wherever the market is on payday, that’s the price you pay for shares. When the market is higher, you buy fewer shares and when the market is lower you buy more, just by virtue of the fact that you are investing the same amount of money at consistent intervals of time.
Lump sum investing is exactly what it sounds like. It is when you take a bunch of money and dump it into the market at the same time rather than spacing out payments.
Some people advocate dollar cost averaging a big chunk of money into the market to minimize risk.
Let’s say, for example, that you have come into $10,000 unexpectedly (congrats!) and want to invest it. Your options are to put it all into the market at once or to split it up into smaller pieces (let’s say $500) and invest it over time.
The thought behind dollar cost averaging here is that you don’t have to worry about putting all your money in and having the market crash the next day.
If you dump $10,000 into the market and lose $1,000 on the first day, that would be pretty painful.
Playing the Numbers
The problem is that the numbers show you’re losing money when you do this.
The market goes up more days than it goes down. This means the odds are that the best time to buy is whatever day you first have access to the money, because stock will probably be more expensive the next day.
If you are investing in installments of $500 each week, then the odds are that you’ll pay more and more with each installment.
Sometimes you won’t. Sometimes the price will be lower. But the general trajectory will be towards more expensive stock and a lower return on investment.
This isn’t just theory. A 2012 study by Vanguard backs it up.
Vanguard compared lump sum investing to dollar cost averaging in the United States, United Kingdom, and Australia. They tested dollar cost averaging spread out over 6, 12, 18, 24, 30, and 36 months in each of country.
What they found was that 2/3 of the time you are going to make more money with lump sum investing than with dollar cost averaging.
This fits with our theory above. If the market goes up more days than it goes down, then it will likely get more expensive over larger time periods.
Earlier is Better
This doesn’t mean that lump sum investing is always better than dollar cost averaging, however. What it really means is that you should put your money into the market as soon as possible.
If you can only afford to invest $100 per paycheck, then you’re better off investing $100 every pay day than saving up to invest that money in a lump sum.
Basically the numbers show that the best time to invest is as soon as possible.
Buy the Dip?
Which brings us back to our opening questions: Should I save up so that I can invest more in the next drop?
As you can guess at this point, the numbers say no.
In theory, investing during a big drop could offset the general pattern of up days and down days that makes stock get more expensive over time. The problem is that we never know when the next big drop will occur.
If you started keeping some cash on the sidelines in 2013, you’ve lost out on a ton of gains. The Vanguard Total Stock Market Index Fund is up about 30% in the last two years alone. You’d need a pretty huge drop just to make up for the gains you’ve already missed at that rate. That’s too much of a risk to take.
So when I say “Don’t time the market!” I mean it. The numbers say you’re going to lose.
Join the Conversation!
Have you tried to time the market? Have you kept cash available to buy dips? What strategies do you like to employ? Let us know in the comments!