Flip on a financial network for more than a few minutes, and you will likely hear a purported expert dispensing advice on when to buy or when to sell in the stock market. But look closely and you will likely see that today’s guru is often a different one from the swami who called the last big market move. The reason is quite simple: timing the market doesn’t work and more often destroys value.
Usually, the most important action to take during times of uncertainty is nothing. Assuming that you have created a sound investment plan and asset allocation that addresses your long-term goals, the key to success is a quasi-magical concept known as compounding that takes advantage of time. For most investors, this is the most important concept to understand because it can be expressed with almost mathematical certainty.
Albert Einstein is often quoted as saying “compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t pays it.” Even if the story is likely apocryphal, the truth it expresses is undeniable. Understanding the force of this concept is perhaps the most profitable lesson in all of investing.
Simply put, compounding is the systematic multiplying of returns upon previous returns over a long period of time. Let’s look at an example.
Consider a $10,000 investment that is expected to earn a 6 percent annual return. In the simplest case, you receive $600 at the end of the first year and decide to plow it back into the original investment. Here’s the magical part: at the end of the second year, you receive $10,600 times 6 percent or $636.00, bringing the total to $11,236 and so forth each year. Returns for one year build upon the principal value plus all of the previously earned returns.
Over a year or two, the effect is not particularly dramatic. But consider a 20-year time frame and the result is startling: $10,000 grows to over $32,000 without adding a single dollar to the pot. At 6 percent, your original investment would double every 12 years.
For many of us, the temptation to nudge the growth along by timing the market is irresistible. But dozens of studies as well as generations of experience have demonstrated that no one has the ability to consistently pick entry and exit points over the long haul, due largely to two factors. First, the direction of the market in the future is entirely unpredictable. Although there can be a certain momentum over the short run, tomorrow’s news is unknowable, sentiment can shift on a dime. Second, because we are human, all investors suffer to varying degrees from well documented psychological biases that color our judgment and negatively affect investment decisions.
Research consistently shows that the average equity mutual fund has returned just less than 10 percent per year over the past 30 years, while individual investors in those funds made less than 6 percent on average due almost entirely to timing decisions, effectively buying high and selling low. Successful investors are much more concerned with staying invested and letting the principal of compounding do the heavy lifting.
If your time horizon for your investments is relatively short, the vicissitudes of the stock market are probably not for you. If, however, you can take the long view, equity investments over time have provided superior returns compared with more conservative vehicles, but the price of admission includes unpredictability in the short run. Timing doesn’t work, but the power of compounding is ineluctable. Successful investors bet on the tortoise to beat the hare.
Christopher A. Hopkins, CFAVice President and portfolio manager
Barnett & Company