By day, Alyssha Swanson teaches second grade. By night, she designs and sells lessons plans through a site called Teachers Pay Teachers.
Thanks to her successful side business, Alyssha has saved $130,000. But it’s earning a paltry rate of interest in her savings account. “My husband and I were going to put the annual maximum into our 401K Vanguard accounts. We were going to invest the remainder in a taxable account. But we’re afraid that stocks might drop. What should we do?”
Many investors ask this question. Some have inherited a windfall. Others, like Alyssha, have saved the money over time. None of them, however, know where stocks are headed. If they invest the money all at once, and stocks drop next week, they could regret their decision. If they add regular sums over time, and the markets creep upwards, they could be equally disappointed.
Will stocks rise or fall? It’s tempting to look for an answer. Some people listen to stockbrokers. Others tune into CNBC or seek wisdom in The Wall Street Journal. But a tea leaf reading might fare better.
Warren Buffett says “Stock market forecasters exist to make fortune tellers look good.” Peter Lynch, the former money manager for Fidelity’s Magellan Fund said, “Nobody has been right [about market forecasting] twice in a row.” Vanguard’s founder, John Bogle says, “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.” CXO Advisory tracked 6,582 high profile forecasts between 2005 and 2012. Coin flippers would have beaten most of them.
So if you have a lump sum, should you invest it all right now? Or should you space it over time? To improve your odds of being right, think like a rat.
Leonard Mlodinow’s book, The Drunkard’s Walk, How Randomness Rules Our Lives, is the top ranked book in Amazon’s fittingly titled Chaos Theory category. The physicist told the story of an experiment where people and rats were required to guess whether a green light or a red light would flash. Before participating, the subjects watched the flashing lights for a while. The color red flashed twice as often as the color green. Other than that, no pattern existed.
Subjects applied two different strategies. Seeing that red was the more likely color, some picked red every time. This resulted in a 75 percent success rate. Most people, however, looked for patterns. Green light selections gnawed at their scores.
But rats didn’t bite. After noticing that red flashed more frequently, they chose the red light every time.
Stock markets movements are like those colored lights. Historically, stocks randomly rise two out of every three years. Other than that, there is no pattern. Because stocks rise more often than they fall, it makes more sense to invest as soon as you have the money.
Jared Bildfell wishes he had known that. The Canadian school teacher had $20,000 in 2010. But he feared investing it all at once. After the market’s big run in 2009, he thought stocks might drop. After all, the S&P 500 had gained 23.5 percent in 2009. The Dow rose 18.8 percent. The Nasdaq leaped 43.9 percent. Experts on CNBC, like economist Nouriel Roubini, said stocks would crash in 2010. “I would invest in short term government bonds,” he said.
By the end of 2010, Vanguard’s short term government bond index (VSBSX) had risen 2.2 percent. By comparison, Vanguard’s S&P 500 index (VFINX) rose 14.91 percent.
Today, Jared kicks himself. “I split the $20,000 into a series of regular investments, which I added over time. The markets kept rising, so I paid higher and higher prices for my investments.”
Lump sum investments don’t always win. But a Vanguard case study found that investing a lump sum, as soon as you have it, usually beats dollar cost averaging. Vanguard compared a series of historical scenarios. They assumed that someone had invested a $1 million lump sum. They wanted to find out if, ten years later, that investment would have grown higher than if the deposits were spaced out over 6, 12, 18, 24, 30 or 36 months?
Vanguard compared rolling 10 year periods for the U.S. market between 1926 and 2011. They analyzed the same scenario for the UK market (1976-2011) and for the Australian market (1984-2011). Lump sum investing won 67 percent of the time. I guess you could say humans should follow rats, not monkeys.
That doesn’t mean you should stockpile your savings. Invest as soon as you have the money. Build a diversified portfolio with more than one asset class. Don’t try to guess where the market is headed. Success won’t come from market timing. Time in the market is more important.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.