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February 16, 2022 — 11 min read

Market timing and the importance of dollar-cost averaging

Josh Pigford

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Josh Pigford

Time in the market is better than timing the market.

Why is this quote accurate? Why shouldn't you try to time the market? Let’s jump into the details here. We’ll start with the definition of market timing , show with data why it’s not such a good idea, and share a simple strategy to follow instead to maximize your returns.

What is market timing?

Market timing is the strategy of buying and selling financial instruments (usually stocks) by attempting to predict and forecast the future behavior of the market.

These predictions can be made based on different factors like:

The problem with timing the market is that it doesn’t actually work. The generally accepted theory (The Efficient Market Hypothesis (EMH), developed independently by Eugene F.   Fama and Paul A.  Samuelson) concludes that it is theoretically impossible to consistently get higher returns than the market.

Fama and Samuelson state that this is because there are millions of investors in the stock market and that stock prices react almost instantaneously to news and events. Profiting from inconsistencies and arbitrage is highly improbable.

According to the EMH, if an investor tries to time the market, it generally results in lower portfolio returns. Several investors, financial professionals, and academics believe that it is impossible to time the market and beating it for any significant amount of time is highly unlikely.

If you'd like to dive deeper into the topic of market timing, tune in to the Ask Maybe podcast episode on this very topic!

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How can market timing hurt your stock portfolio?

  1. Rebalancing your portfolio
  2. Setting a target allocation to each asset class (stocks, bonds, real estate, gold, etc.)
  3. Reducing investment fees (fees compound over time as well) and
  4. Ensuring that you're adequately diversified.

Why even timing the market perfectly doesn't make a huge difference

So timing the market can really hurt you. But it can be worth it if you do it perfectly and make a killing, right? Well, no.

Let’s look at a quick story backed by data that shows that even if you manage to time the market consistently, the returns don't vary by a lot in the long run.

Let’s consider three investors:

Take a look at each investor’s extended internal rate of return (XIRR) based on the recorded data of market highs and lows between 1928-2020:

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(Source: Yahoo Finance)

Let’s look at those percentages more closely. The difference between Mr. Unlucky and Mr. Doesn’t Care is 0.2%. The difference between Mr. Doesn’t Care, and Mr. Lucky is 0.29%. And the difference between Mr. Unlucky and Mr. Lucky is 0.49%.

All three investors, including the investor who had perfect market timing every year for 92 years, ended up within a range of 0.5% of each other.

That’s not a big difference.

And that hypothetical situation doesn’t consider the realities of the market—for example, that it would be practically impossible to buy at the absolute top or bottom of the market every year for 92 years.

Let’s look at the same returns in terms of ROI. If all three investors invested $1000 every year (Total investment $94,000) from 1928 to 2021, this is what each investor’s portfolio would look like on a Return on Investment (ROI) basis:

| Strategy | ROI on $94,000 invested |
| Buying the S&P 500 at Yearly Lows (Mr. Lucky) | 144.9X |
| Buying the S&P 500 at Years End (Mr. Doesn't Care) | 116.5X |
| Buying the S&P 500 at Yearly Highs (Mr. Unlucky) | 100.1X |

Another caveat is that it is highly improbable that anyone can time the market consistently for even a few years (let alone for 94 years). The reverse is also true because it is very difficult to buy at market peaks year after year consistently (no one is that unlucky). Finally, you can minimize variability in portfolio returns further by investing every month instead of yearly.

Trying to time the market also incurs enormous fees in the form of brokerage and other transaction costs, taxes, and spreads between buying and selling prices (bid-ask spreads). Fees and taxes further reduce your portfolio returns as repeated buying and selling can incur substantial transaction costs and taxes.

The final point against trying to time the market is that most investors who try and time the market lose out on a huge percentage of market returns as emotions such as fear and greed make it difficult to reenter the market and result in panic buying/selling.

All this, combined with the fact that we are susceptible to a wide array of cognitive biases, shows that m arket timing does not help generate excess overall portfolio value/returns.

How to reliably grow your portfolio without timing the market

Now that we know that timing the market is not a factor that significantly affects the value of your portfolio let’s look at the factors that do. The significant drivers of portfolio returns (discussed in detail below) are diversification, rebalancing, indexing, dollar-cost averaging, and fees.

In simple terms, as an individual investor, the best way to maximize your portfolio returns without trying to time the market is to:

Following the above principles and focusing the bulk of your attention on these pillars of investing will have a significant positive effect on your final portfolio value.

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