The S&P 500 had a rough start to the year 2020. It climbed a little, dropped a little, climbed a little again, then started falling – and kept falling – until, in the third week of March, it was down 34 percent from its high.
At about the same time, shutdowns related to the COVID-19 ground the US and world economies to a virtual halt.
Times like these can be scary for even the most seasoned investors. However, before you let a situation like this cause you to make radical changes to your Thrift Savings Plan (TSP) or other investment accounts, be sure you first understand the challenges of trying to time the market and the potential benefits of the age-old investment concept of dollar cost averaging.
Predicting When Investment Values Will Go Up or Down
Trying to buy or sell investments to maximize profits based on when you think they will increase or decrease in value, is known as market timing. And tempting though it may be to try, it doesn’t work…at least not consistently.
It’s nearly impossible to know when the value of an investment will go up or down, or how far it will go in either direction when it does. For example, the U.S. economy was roaring at the end of 2019, unemployment rates were flirting with historic lows and the S&P 500 was up almost 30 percent for the year. With this information in mind, on January 1, 2020, could you have predicted the graph above?
Would you have been able to guess that in just a few short months a global pandemic would wreck the world economy? Or that when it hit, all of the market gains from 2019 (and then some) would be wiped out in just over a month? Or, that just a month into the pandemic, with tens of thousands of businesses closing and millions of people losing their jobs, the S&P 500 would climb almost 30 percent in a little more than a month?
If you don’t think you could have seen these events coming, don’t feel bad, the best minds in business, academia, and government weren’t able to predict them either. This is just one example of why financial professionals discourage market timing as an investment strategy and why you probably shouldn’t try it.
A Potentially Better Approach: Dollar Cost Averaging
Rather than try to avoid market volatility, a potentially better approach might be to try to use that volatility to your advantage to buy less investments when their price goes up and buy more when their price goes down. Even better, if you can automate this approach, you won’t have to pay attention to when those prices changes occur.
Welcome to dollar-cost averaging.
Implementing a dollar cost averaging strategy involves five simple steps as you see in the box to the right. First, determine the investments you want to begin purchasing. Then, decide how often you want to purchase them (i.e. each time you get paid, a set day of the month, etc.). Next, decide how much to invest each time. Then, to take your emotions out of the equation, set up your purchases to happen automatically through either payroll deductions or automatic transfers from your bank account. Finally, with your plan in place and with the knowledge that you’re playing the long game, ignore the day-to-day, week-to-week, and month-to-month economic and market headlines.
Of course, there will still be ups and downs in the markets as well as in the value of the investments you’re purchasing. Dollar-cost averaging doesn’t change that, nor does it guarantee that you’ll make money. However, it can give you the peace of mind that you’ll be buying more shares when the price drops and less shares when the price goes up. All things being equal, the more shares you own when it comes time to sell them and use them in the future, the more money you’ll have.
Fortunately, if you’re investing in the TSP, you’re already engaging in dollar cost averaging.
A Tale of Two Markets
To better understand how dollar cost-averaging can work, let’s compare investment results from two hypothetical markets that behave very differently. One will be an investment that steadily increases in value (Risking Market). The other will be an extreme example of an investment with a price that swings widely from month to month (Fluctuating Market).
In both examples we’ll assume a Marine invests $250 per month into and investment that costs $25 per share at the beginning of the year and $41 per share at the end of the year.
The tables on the next page capture the details and the results. As you will see, both scenarios involve investing a total of $3,000 and both result in profits for the Marine. However, the Fluctuating Market example results in a bigger profit by year-end. Look closely at each table to see if you can determine why this is the case.
As shown in the results table above, the Marine purchasing this steadily increasing hypothetical investment earned a profit. Three thousand was invested into shares that were worth $3,824 by year end, for a 27 percent return. And while the price of this investment gradually increased over the year, compare the results to the hypothetical investment below where the price fluctuates wildly over the year, both up and down, but starts and stops at the same prices.
The Marine in this example also made money. However, because her dollar cost averaging strategy resulted in her buying more shares when they were cheaper and fewer shares when they were more expensive, she made more money. She made a total of $1,195, or a 40 percent return compared to the 27 percent return in the first example.
It’s important to point out again that implementing a dollar-cost averaging strategy does not guarantee you will make money investing. However, it does eliminate the guesswork associated with trying to time the market, and it could provide the peace of mind necessary to help you avoid poorly timed investment moves. It may even result in a less stressful investing experience in times like those referenced at the beginning of this document.
Help is Available
Your Installation’s Personal Financial Manager (PFM) and/or Command Financial Specialist has additional Investment Education resources to assist you.