The economic tumult brought on by COVID-19 reminds us, once again, that trying to time the market is a fool’s errand. Following the zigs and zags of stock values during the first quarter of 2020 was like watching a high-speed Wimbledon match; you risked giving yourself financial whiplash. And trying to time your trading to profitably coincide with those zigs and zags? Impossible.
So what can you do in a topsy-turvy market that has spun out of control? How can you maximize your gains and limit your losses? For me, the answer is simple. I do what I always do; I stick to my plan.
Having an Investment Strategy is Crucial to Building Wealth!
Successful investing isn’t about predicting market trends. It isn’t about bobbing and weaving in an effort to constantly “buy low and sell high.” And it definitely isn’t about following stock charts daily and reacting to economic news as it happens. In fact, when done correctly, investing can be a remarkably hands-off activity. The best investors stick to just three basic rules to ensure that they come out ahead.
These aren’t fancy or complicated rules. They don’t contain “hot tips” or insider information. Honestly, they are pretty basic and downright boring. Yet together, these rules make up the most reliable investing plan there is. And it’s used by novices and experts alike!
Commit to playing the long game
If you look at stock values by the day, you’ll see a remarkable amount of volatility. A share price that is trending upwards at 9:00 a.m. can take a plunge before lunch. By the afternoon, it might be on the rebound, only to drop again right before the closing bell rings. This is common. Prices are a reflection of real time news and the ongoing negotiations between buyers and sellers over the value of a stock share at a specific point in time. (Read this article to find out more about where stock prices come from.) If you only studied daily stock charts, you’d have the impression that the market is simply too risky and unpredictable to invest in.
However, if you take a step back and look at those charts over a week, a month, or a year, a new pattern emerges. All of the daily activity begins to level. The temperamental, short-term gains and losses smooth out. What used to be an unpredictable morass of highs and lows becomes a steady climb upwards, reflecting an overall return of about 7%. But the only way to benefit from this steady climb upwards is to stay in the game. Investing needs to be on a long-term schedule because the benefits are on a long-term schedule. You should plan on leaving your money in the market for a minimum of ten years. Twenty is even better.
Use dollar-cost averaging
Creating profitable returns is a bit like gardening. You don’t just throw some seeds on the ground and wait for them to sprout, do you? Of course not. You water them regularly to make sure they reach their potential. So think of stock purchases as planting your seeds. Regular contributions are the water they need to grow. Planning out your contributions with the dollar cost averaging method is the best way to ensure that your money never dries up.
With dollar cost averaging, you decide on a set amount of money to invest at regular intervals. It might be $25 a month or $100 a week. There’s no magic number; consistency is more important than the amount. Once you establish your amount and intervals, you commit. You invest $100 when the market is up; you invest $100 when the market is down. You purchase lots of shares when prices are low, you purchase fewer shares when prices are high. No matter what the market is doing, you continue to invest according to your system. If you combine dollar cost averaging with investing for the long haul, your gains will more than offset your losses. You will come out much further ahead than you would have if you tried timing the market for all of those years.
Another benefit of dollar cost averaging is that it takes the emotion out of investing. You don’t have to follow stock prices daily and try to figure out which way you should go based on the news. You won’t sell out of fear or buy out of greed. You’ll be a controlled and dispassionate investor. Those are the people that build real wealth. You can find out more about dollar cost averaging, with concrete examples, in this post.
Rebalance
Rebalancing is a periodic assessment of your portfolio. It’s a kind of audit where you make sure that your original allocations are still in place and make adjustments if they’ve drifted off course. Luckily, rebalancing is only an occasional activity. It’s not necessary to do it more than once a year, if that. Here’s how it works:
I set up my investments so that 20% of my money is in higher-risk stocks and the remaining 80% is in bonds. I do this because I’m a conservative investor; I am only willing to expose a small portion of my money to risk. For the sake of simplicity, we can say that I’ve invested $1,000, which comes out to $200 in stocks and $800 in bonds.
During an incredible bull run of a few years, I find that my stock investments have done really, really well. In fact, my original investment of $200 has grown to a $700 value! My bonds, meanwhile, have made smaller gains. My original investment of $800 is now worth $1,200.
Some quick math shows that my allocations are now off-balance. With a total of $1,900 in the account, stocks make up 36.8% and bonds make up 63.2%. This is not what I wanted. EVEN THOUGH the stocks served me well, I’m still not comfortable having them represent more than 20% of my total portfolio. I sell some stock investments and buy more bonds until I am back to my 20/80 allocation. Moving forward, I can rest easy knowing that 80% of my portfolio is still protected from undue risk. You can read about rebalancing, with more examples, here.
How These Boring Rules Saved My 529 Plan
I invested in a 529 plan for my daughter in 2004. The plan is a “target date fund,” meaning that it picks a mix of investments that are intended to provide the fund with growth until the target date is reached. At the time of the account opening, I planned to contribute regularly to the fund for a minimum of 17 years. That follows rule #1: commit for the long haul.
My regular deposits started at $50 a month. The money was taken via a direct withdrawal from my account, so I never had to worry about missing a payment. That amount was applied every period without fail, as stated in rule #2: use dollar cost averaging. When prices were low, the $50 bought more shares. When prices were high, the $50 didn’t go as far. Later on, when I was able to budget for it, I increased my monthly contributions to $100 and eventually $150, but the same rules of dollar cost averaging always applied.
A 529 fund takes on more risk in the early years. This allows for the chance to earn higher returns, of course, while the remaining time in the market helps the account recover in case of losses. As the fund gets closer to completion, money is moved away from riskier investments and into safer ones. This protects the capital in the later years so I have the money available to me in 2021. This is an example of rule #3: rebalancing. The great thing about target date funds is that rebalancing is done automatically.
When the market started tanking during the first part of 2020, I knew that my 529 plan would take a hit–but how much of one? Since it was getting close to maturity, I hoped that the majority of the money would be in safer investments that could withstand a crash. Thankfully, I was right. Here are some charts to show how it works:
Yeesh. The account was worth about $66,000 at the beginning of the year. There was a market dip in early March, a recovery (almost to the original 66K), and then a ghastly plunge that took it below $58,000. Toward the end of March, it started climbing back up, kind of in a “two steps forward, one step back” way, and by the beginning of April, it was up to $62,000. If COVID gets under control and business goes back to normal, I can (cautiously) assume that the account will recover and eventually surpass the $66,000 mark. Since it is a 2021 account, I still have time to wait for that recovery.
Percentage-wise, here’s how much my account lost during the crash:
The last calendar quarter was fairly brutal with my fund losing 8.45% of its value. If you take an average that started at the beginning of the year, the losses are 5.40%. These are not nice numbers to look at, but I take comfort in the “since inception” figure at the far right of the graph. Even with the current beating the fund has taken, it has still returned an average of 5.89%. With another year or so, I think it can hit the 7% average that most long-term investments earn.
The next chart provides an interesting look at 529 plans that mature later than mine. Those accounts sustained much bigger losses. Why? Because they are on a different timeline. The plans that mature in five or ten years are designed for more risk. The plans that mature in a year or two aren’t. Look at the steadily declining percentages for the 2024, 2027, 2030 plans and beyond.
The later portfolios lost more than I did, but they also have more time in the market to make that money back. That is classic rebalancing in action.
Conclusion
We can’t predict the movements of the stock market. When faced with an uncertain situation, then, the best we can do is stick to a well-thought out plan. All of the strategies in this post–long-term investing, dollar cost averaging, and rebalancing–are proven approaches that will limit your losses and provide you with the best overall return on your investment. Not only that, they ensure that investing is an intellectual activity that requires you to rely on consistency and objectivity–not emotion. I know that most of us like to fantasize about discovering the next Amazon or Google stock and making a mint with our stock market prowess, but those instances are rare. Boring, it turns out, is the new “exciting” when it comes to creating wealth.