Monday, January 25, 2016

How Should New Investors Enter the Market?

A reader, T.S., asked the following interesting question (edited for brevity):
“I have become convinced about index investing. But as a recent investor, my issue is how to begin. For example: Is now a good time to enter the market? Or how would one begin investing at this time given economic head winds, declining consumer disposable income, market distortions from the central banks and governments, and the current market valuations?”
T.S. went on to examine a number of factors:
— Cyclic patterns in the past 55 years of stocks returns
— The Shiller 10-year price to earnings ratio history for the past 135 years
— Volatility of stocks for the past 3 years
— Goldman Sachs earnings projections for S&P 500 companies for the next 3 years
— Currency fluctuations

He finished with the question:
“So what advice do you offer your readers for people who are but starting to invest in the stock market?”
As usual, I’ll begin by saying I don’t offer advice. What I can do is explain how I see things and how I choose to invest myself.

You should be deeply suspicious of market projections. There are smart people who offer a view of the future because they want to help investors. An example would be those who caution that the next decade’s stock returns could be lower than past returns. However, there are many more people who make projections to further some end of theirs; these people seek to mislead rather than inform. Mainly they mislead by giving the impression that they can predict the future.

There are a great many brilliant people who have devoted their working lives to studying the same information T.S. was examining. Stock prices reflect a consensus view of the future. They already take into account all the information available today. This stock price consensus may be flawed sometimes, but I can’t divine the future better than so many brilliant people, so I don’t try.

The consequences of this conclusion are powerful. I’ve decided that spending my time studying stock prices or any other macroeconomic data is useless. After poring through all the information T.S. was studying, I have no better idea of what will happen to stocks than if I had taken a nap.

T.S also mentioned the current scary-looking conditions of “economic head winds, declining consumer disposable income, market distortions from the central banks and governments, and the current market valuations.” Things always look scary as you live through them. Only in hindsight do we get the illusion of certainty. If you wait for certainty, you’ll be waiting forever.

I’ve chosen an asset allocation and have decided how I will change it after I retire. I stick with this plan regardless of what happens to stocks. I make no tactical moves in response to recent market movements. I prefer “recent market movements” to the phrase “current market conditions” because the latter gives the illusion that what has happened in the recent past will persist into the near future.

So, if I were just starting out investing today, I’d begin by choosing an asset allocation based on the long-term returns history of stocks, bonds, real estate, and cash. Then I’d begin investing a fraction of my pay each month based on this allocation, keeping costs as low as possible.

If I were starting with a large sum of cash, I’d consider dollar-cost averaging into my investments. I might choose to invest it all at once today, but if I was worried about investing at an unusually bad time, I might invest 10% every couple of months for the next year and a half. Investing it all right away gives higher expected return, but easing into the market reduces risk.

However, my decision of whether to invest all at once or to ease into the market would not be based on “current market conditions.” I don’t believe I have any useful insight into what will happen with stocks over the next day, week, month, or year. I’m just hoping the past trend of stock indexes giving positive returns during almost all decades will continue.

So there you have it. Investing has become quite easy for me now that I’ve let go of my illusion that I might be able to see the future.

7 comments:

  1. I predicted last week that you would state that you can no longer see the future.

    If I could see the future, why would I tell anyone else? I answered a reader with that statement, and they got very upset with me. I really have to figure out what tags you need to put on things to signify you are writing humor (or sarcasm).

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    1. @Big Cajun Man: I always knew you were holding back with the secret for getting rich. You're so secretive that you're not using it yourself for fear that someone else will figure out how it works.

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    2. My students often ask me the same question. Sir, when is the best time to start investing? Easy answer : Yesterday.

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    3. @Jamie: That's a good answer for starting to accumulate savings in small amounts. For someone who already has a lump sum, the answer I usually give is "whenever you've got some money you can live without for 5 years."

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  2. This is what I've in the past as well, since I cannot predict the future, I just slowly added money i.e., invested a bit every few months.

    The best decisions in life of course always exist in the rearview mirror!

    Mark

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  3. Replies
    1. @Glenn: Well said, assuming "nap" means holding a broad index of stocks. "Don't just do something. Sit there!"

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