Once upon a December 2018, there was an investor named Alex.* The stock market had gone on quite a ride over the past few months, and Alex was stressed from all the ups and downs. So she decided to take her money out of the market until things cooled off a bit.
The next day, the market took “its ugliest Christmas Eve plunge ever.” Alex was happy — she’d avoided the big drop! But then came December 26, the market’s best day in nearly ten years. She “avoided” those big gains, too.
Alex is a smart person, right? So how did things go so wrong? And what can we learn from her mistakes?
Is now a good time to invest?
Good question. Here’s the short answer: Yes ... but yesterday probably would have been even better.
Because every single day you wait could cost Future You about $100. That’s like having $4 deducted from your bank account every single hour of every single day. Or taking a pay cut of more than $17 an hour. Or giving up about $3,000 in income every month. Um, no, thank you. (Here’s how we calculated that.)
This is thanks, primarily, to two things: First, the market has historically trended upward over the long term. And second, the power of compounding. That’s what happens if your investments earn money, and then that money earns you even more money. And so on.
So historically, the most successful approach to investing has been to tune out all the noise about “hot stocks” and predictions about what the markets will or will not do. Instead, invest consistently, a bit out of every paycheck, with an eye on the long term.
Why timing the market doesn’t work
The best time to invest is yesterday? But what if I’d done that, and then the market crashed today? Or what if tomorrow’s stock prices ended up being even better? How do you know that yesterday is best???
Well, that’s the point ... we don’t know. BUT neither do the guys on TV. And neither did Alex. And neither do people who are literally paid to know. Nobody can know what’s going to happen with the stock market or the economy — everyone’s just guessing. They’re trying to “time the market.”
What does it mean to time the market?
You may have heard the phrase “buy low and sell high.” It means trying to buy a stock when its price is at the lowest point and then sell it when the price is at the highest point.
If you could successfully buy low and sell high over and over again, consistently, then your returns (aka the money they made) would be preeeeetty impressive. Probably better than what you’d have made if you’d just left your portfolio alone. You’d “beat the market.”
But how do you know when the price is lowest — or highest? How do you know it won’t drop more, or that it won’t rise more? Again: You don’t. Again: No one does.
What should you do instead?
Since you can’t know when the best moment to buy or sell will be, you could instead invest regularly — $100 a month, for example. Sure, sometimes you’d be investing at a “bad time,” but you’d also be there for good times, too. The technique of investing consistently, no matter what’s going on in the market (also known as dollar-cost averaging), takes the guesswork out of the process.
Here’s an example: Imagine the market dropped for a couple months and then came back up again.
Look what would have happened if you’d invested consistently that whole time. As the market price went down, you’d have bought more shares of stock for the same dollar amount of investment. After six months, $600 would have bought you 36 shares of stock, for a total portfolio value of $720.
But look what would have happened if you’d started investing, then stopped while the market was down, and then started again once it began to recover. Because in this scenario, you waited until the end to buy your shares, you missed the opportunity to buy them “on sale.” In this example, $600 would have bought you only 27 shares of stock, for a total portfolio value of $540.
You’d have invested the same amount of money in either scenario, but by using dollar-cost averaging, you’d have ended up with more shares of stock (thanks to their prices being low for a couple months there) and a higher portfolio value overall.
That whole buying stocks “on sale” during market downturns has helped investors in the past. Consider this: If you’d invested in the stock market in 1929 (cue ominous music, because the Great Depression is about to hit) and then stopped adding to your account, it would have taken you more than 25 years to recover your investment. But if you’d kept investing at the beginning of every year after that, it would have taken you less than seven years to recover.
It was even faster for 2008: If you’d have invested at the market’s peak in late 2007 and then stopped, you’d have recovered in about five years, but if you’d invested regularly throughout, you’d have recovered in less than two years.
Of course, the effect of big economic plunges like that on people’s spending money can make it harder to keep investing regularly, but those are extreme examples. The bottom line is this: Historically, investors have often been able to recover the money they lost from market downturns faster if they kept investing regularly rather than waiting it out.
Plus, trading too often can really cost you
There’s this thing called capital gains tax. Let’s say you own an investment and it goes up in value. The minute you sell that investment (and earn a profit on it), that’s called a capital gain. And it counts as taxable income. Your tax rate on capital gains depends on how long you owned the investment for, too. The short-term (less than one year) capital gains tax rate is generally higher than the long-term rate.
So if you buy and sell stocks often in order to try to take advantage of price swings, you could trigger those taxes. And on top of that, investors often incur a trading fee every time they decide to buy or sell something. Those fees can add up.
So. In order for timing the market to (literally) pay off, you don’t have to just beat the market — you have to really beat the market. You have to do so much better than the market that those taxes and fees don’t eat into your profits.
Not even “experts” can reliably time the market
In one study, S&P Dow Jones looked at the top 25% of actively managed mutual funds from 2010. “Actively managed” means a person (or team of people) decided which individual investments to include in those mutual funds in order to earn good returns. (Btw, these guys’ salaries are … significant.)
That study looked at the 2,862 actively managed mutual funds that performed the best in 2010. Guess how many of them also did well in 2011? Go ahead, guess.
One more time: Nobody knows what the markets are going to do.
One more time: Nobody can consistently time the market.
Investing is about time, not timing
OK, so that explains why timing the market isn’t a good idea, but what about that whole “yesterday” thing? Why yesterday, and not today? Or tomorrow? Or next year, when you think you might — you know you will — get a raise and have a little more money to invest?
This is where two important factors come into play: First, the historical performance of the stock market over the past century or so. And second, the mathemagic of compound returns.
How the stock market has behaved historically
Here are the annual total returns of the S&P 500 (a stock index that includes the largest 500 publicly traded companies in the US) over the past 12 years:
Let’s say you invested money at the beginning of 2008. If you’d then taken your money out at the beginning of 2009, you’d probably have been pretty sad (peep that big drop). But if you’d left your money invested that whole time, through the end of 2018, you probably wouldn’t be sad at all right now.
(Of course, there’s no guarantee that the markets will continue to behave as they have in the past … but it’s something to think about.)
This is where things can start to really heat up — if the money you’ve earned also earns money.
Take an example. If you were to invest and earn a positive return — say, a hypothetical 6% a year — you wouldn’t just earn 6% of your original investment every year. You’d earn 6% of the total balance in your account.
A 6% return on a $100 investment is $6. So after one year, your new balance would be $106. Got it. Then for the next year, you’d earn 6% on $106 ... so $6.36 (which, of course, is more than $6). Then for the following year, you’d earn 6% of the new total of $112.36. And so on and so forth.
In this hypothetical scenario of a consistent 6% annual return and no significant taxes or fees, each year you’d be earning more than you’d earned the year before. (Mathemagic.)
OK: That scenario would be pretty unusual, because year-to-year returns aren’t always going to be positive (or consistent). That’s why we say that investing comes with risk. Compounding can work against you, too — like if you only invested for a few years, all of which were during a recession. (Imagine losing a compounded 6% each year instead of gaining it.) However, as we said, the stock market has grown over the long term — 9.5% annually, in fact. So it’s been historically true that the longer people left their money invested, the more likely they’ve been to end up better off than they were when they started.
So, how long is long enough to let my investments grow?
That depends. The longer until you’re going to need the money you’re investing, the more risk you can afford to take with it. You’ll have more time to let the market recover from any potential downturns that happen while your money’s invested.
That’s why the investment portfolio that’s built for your retirement accounts — which you won’t need to tap into for 20, 30, 40 years — can usually include a lot more risk than a portfolio built to help you put a down payment on a house in six years.
Here are some guidelines based on how much time you have to invest:
If you need the money in three years or less
With a short timeline, you probably aren’t going to want to take much risk. This is what low-risk investment accounts are built for, like money market accounts, funds that invest in low-risk bonds, or certificates of deposit (CDs). High-yield savings accounts might also be a good fit in this scenario.
If you won’t need the money for several years (or longer)
This is where stocks (aka “equity”) usually come into play. They’re typically the riskiest type of investments included in a portfolio because the stock market can be so volatile. Stocks are often “balanced out” in a portfolio with bonds, which are usually safer. (Here’s some more info on stocks and bonds and how they might make money.)
The longer you have to invest, the more of your portfolio can be made up of stocks. As you get closer to the day when you’ll need your money, you can shift that allocation to include less stock and more bonds.
This is what’s known as diversification, aka investing in different types of securities that behave differently from one another and are affected by different external factors. That way, if some event were to bring one type of investment down, that event would impact the other investments in a different way. That’s why diversification can help make your overall investment portfolio less risky.
Ellevest does this math for you
Yup. When you invest online with Ellevest, we use info from your real life — like your finances, background, and gender (more on that in a minute) — and combine it with how much you need and when you’re going to need it. Then we suggest a plan to help you get there.
If you follow our plan, we’ll recommend an investment portfolio that’s designed specifically for your goal and timeline — with the amount of risk that we calculate you should take in order to get you to your goal by your deadline in the majority of market scenarios. (And yes, we include the possibility of radical up-and-down markets in our data when we calculate those projections.) This is called goal-based investing.
So, for example, let’s say Elle is a 30-year-old woman who makes $65,000 a year working in the tech industry in NYC. We calculate the retirement income we expect she’ll need by age 67, and we recommend that her portfolio start out with 96% stock. But for an investment portfolio designed to get her that 20% home down payment in 6 years (based on how big a mortgage we expect she’ll qualify for, using her income), we only recommend 46% stock. We’d automatically adjust the allocation in both of those portfolios as she got closer to the end of her timeline.
So don’t listen to the noise
When you see news articles about “this stock being way up” or “that market index being way down,” here’s what you do: Keep calm and invest on. Tune it out. There are plenty of other things you can do to be responsible with your investments.
You can make your investment deposits automatic and schedule them for regular intervals. Then you can check in on them every once in a while, maybe when you get your quarterly statement.
Another good thing you can do for your money is to make sure you know what you’re paying in fees. Those can seriously cost you over the long term. Here’s a guide to finding your fees so you can know if what you’re paying is worth the money.
One caveat: When “now” isn’t actually the best time to invest
When you’re still working on getting your financial basics into place first. We generally recommend waiting to invest until you have these things checked off your list:
Get a handle on what’s coming in and going out so that you know you’ve got your expenses covered. We recommend using the 50/30/20 rule as a high-level budget guideline. (And if the idea of finding extra money in your budget for investing seems out of reach, that’s OK. Get yourself into a rhythm, and then start to look for ways you can either reduce your bills or increase your income. Baby steps forward still move you in the right direction, after all.)
Pay off debt that has an interest rate above 5% — that’s historically been likely to cost you more than you’d otherwise earn by investing. Here are some techniques for paying it off.
Build an emergency fund of three to six months’ worth of take-home pay. That security is important because financial emergencies are practically guaranteed to happen sometimes. Here’s all our advice about emergency funds — how much, where to keep it, etc.
If your job offers a 401(k) employer match, though, try to take full advantage of that while you’re paying off debt and building your emergency fund. Here’s what you need to know about 401(k) matches and why they’re such a big priority.
Why this is especially important for women
This we know: There’s a big gender investing gap. Women retire with two-thirds as much money as men and then live an average of 6–8 years longer. There are a lot of reasons why, including the fact that women take more career breaks, get paid less, and see their salaries peak a decade earlier in their lives. (BTW, Ellevest’s platform takes these things into account.)
Nope. Not cool. But it’s the reality of the situation. And it means two things (at least): First, that we have no time to waste. If we don’t start now, we’ll be even less likely to catch up. And second, catching up is probably not even enough, because of that whole living longer thing. So let’s take advantage of every opportunity we have to use smart investing practices designed to help solve this problem.
Alex isn't real. We made her up. But the market changes we used to tell her story? Yup, those are real.
Source Ellevest. To calculate “about $100,” we compared the wealth outcomes for a woman who begins investing at age 30 with one who began investing at age 40 after having saved in a bank for 10 years. Both women begin with an $85,000 salary at age 30 and all salaries were projected using a women-specific salary curve from Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., which includes the impact of inflation. We assume savings of 20% of salary each year. The bank savings account assumes an average annual yield of 1% and a 17% tax rate on the interest earned, with no account fees. The investment account assumes an investment with Ellevest using a low-cost diversified portfolio of ETFs beginning at 91% equity and gradually becoming more conservative during the last 20 years, settling at 56% equity by the end of the 40-year horizon. These results are determined using a Monte Carlo simulation—a forward-looking, computer-based calculation in which we run portfolios and savings rates through hundreds of different economic scenarios to determine a range of possible outcomes. The results reflect a 70% likelihood of achieving the amounts shown or better, and include the impact of Ellevest fees, inflation, and taxes on interest, dividends, and realized capital gains. We divided the calculated cost of waiting 10 years to invest, $337,657, by 3,650 (the number of days in 10 years). The resulting cost per day is about $92.50. Dividing that result by 24 hours results in $3.85 per hour.
To translate that result into pay rates, we assume a 30-day month, resulting in a cost per month of $2,775. We then assume the average number of hours worked per month is 160 (40 hours per week multiplied by 4 weeks), resulting in an hourly cost of $17.34.
The results presented are hypothetical, and do not reflect actual investment results, the performance of any Ellevest product, or any account of any Ellevest client, which may vary materially from the results portrayed for various reasons.
© 2019 Ellevest, Inc. All Rights Reserved.
*We assume the first woman begins with an initial investment of $0 at age 25 and deposits $250 per month for 480 months (40 years) into an investment account that earns an after-fee annual return of 6%, which compounds monthly. We assume the second woman begins with an initial investment of $0 at age 45 and deposits $500 per month for 240 months (20 years) into an investment account that earns an after-fee annual return of 6%, which compounds monthly. The results are shown without the impact of inflation. For illustrative purposes only. The projections of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
You may or may not have noticed that we linked to a page on nerdwallet.com as the source for capital gains tax rates. FYI, NerdWallet, Inc (“Solicitor”) serves as a solicitor for Ellevest, Inc. (“Ellevest”). Solicitor will receive compensation for referring you to Ellevest. Compensation to the Solicitor will be no more than $175 per client. You will not be charged any fee or incur any additional costs for being referred to Ellevest by the Solicitor. The Solicitor may promote and/or may advertise Ellevest’s investment adviser services. Ellevest and the Solicitor are not under common ownership or otherwise related entities.
Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.
The practice of investing a fixed dollar amount on a regular basis does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.
The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.
The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.
Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.