Isaac Newton may have been one of the greatest mathematicians of all time, but he couldn’t figure out how to remain solvent. In the early 1700s, Sir Isaac sold his shares in the South Sea Company after reaping a handsome profit. But as the story goes, he got back in later at a higher price because his friends, who still held the shares, were making a killing. Things could have ended happily for Newton (despite his horrendous decision to buy because everyone else was doing it) as South Sea continued to skyrocket. He had plenty of opportunity to liquidate at an attractive price, but he was apparently waiting for the perfect price. In so doing, he rode the stock all the way down and was financially ruined.
When it came time to sell, Isaac Newton sacrificed good returns in pursuit of great ones. It is possible to do the same thing in making a decision to buy.
Occasionally, a client will send us money with the stipulation that we wait for “the right time” to invest it. This usually means holding out for a 5% or 10% correction from current levels before adding to stocks. Establishing price targets on the market seems rational given that downturns of 5% to 10% in a single month have not been uncommon historically. The ability to buy at lower prices is obviously advantageous, if the opportunity arises. But there is also a danger in demanding a sell-off before investing.
For example, consider two hypothetical investors on 3/1/09. Stocks had fallen by about 50% since the 2007 high, and there was reason to believe the volatility would continue. Client A swallowed hard and put $10,000 into the S&P 500 on that date; Client B wanted to wait for an additional 10% decline to make the purchase. Where did each one stand as of 12/31/13?
Client A’s money almost tripled in less than five years while Client B’s funds were never invested (a 10% decline from the 3/1/09 level has yet to occur). Obviously this is an extreme example because the selected period originated at a market bottom. But the point remains: if stocks take off, downside price targets may go unfilled. The longer stocks run, the less chance they will come back to the initial level.
We examined historical returns for the S&P 500 to determine the percentage of time downside price targets were not met:
Put simply, if you had chosen to wait for a 5% decline to invest from each monthly starting point in history (1/26 – 6/13), you would have only invested a bit more than half the time. Holding out for more significant downswings would have provided even fewer instances to buy (caveat: a future market decline so severe that it plunges through some or all of the historical downside targets is possible but seemingly unlikely for all but the most recent starting points. If a target is reached, it usually happens within a year.).
While it is always beneficial to “buy low”, trying to extract an extra 5% - 10% may not be worth the potentially huge cost of foregoing the investment altogether. No strategy guarantees success, but the long-term investor is seemingly better off to pocket solid returns than to tinker with the timing. We think Sir Isaac would agree.
Aaron Pettersen, CFA, CFP®