In our series of investing rules articles, we last talked about putting parameters around our investing to mitigate single stock risk and stock picking risk through the use of maximum allocations and balancing between index funds and single stocks. Today we’re going to continue discussing this topic as we look at when we buy stocks.
First, let’s quickly review the context. For our purposes here we are breaking down all investors into two categories. Those who invest their money via automatic investing methods such as a 401(k) plan and those who invest their money at their own discretion, when they want and how they want. Yes, we’re aware that some investors fall into both camps.
We’re attempting to establish rules for those investors falling outside the automated, 401(k)-like investing schedule. The point here is that when we invest money outside of an automated schedule into a set group of funds, we need to establish some ground rules. These ground rules have a single purpose: protect you from you.
Investing is hard and emotional. Moreover, countless studies back up the idea that your long-term returns suffer if you leave investing decisions to not much more than your feelings on recent market activity, the latest stock recommendation blog post you read or a hunch you have on a particular company. We need boundaries and guard rails in which we can operate and make investment decisions. Today’s guard rail topic is all about timing. When to buy stocks. When to rebalance. When to put new money into the market. So with that said, let’s dive in.
Is market timing possible?
As we discuss timing, we’re going to base much of our discussion on two assumptions. First, timing the market is impossible. That is, to make investment decisions based on the idea that you know what direction the market will take during short or medium time horizons is not a sustainable, long-term strategy. In fact, attempting to do so almost always leads to under-performance for most people.
The second assumption might be considered an exception to the first assumption. Our next assumption is that major market crashes can occur once a decade or so, and our investment rules might warrant making some extra aggressive moves during these times depending on circumstances around age, retirement planning, job security and more.
You might note that this assumption is based on an assumption that markets will always rebound and go higher over time. We are indeed assuming that equities markets over the long haul will offer good returns.
Investing rules for when to buy stocks
Timing Rule No. 1 – Setup a regular schedule for when you’ll contribute money and buy new investments.
You might think of this situation as similar to having a 401(k) pull money out of your paycheck each pay period and invest the money. Having a set schedule will essentially eliminate the stress and question of when you should add to your investments. To keep this simple, you might do it every pay period or you might do it monthly. You might find a way to automate this. Many people do.
Timing Rule No. 2 – Buy the same stuff over and over again according to your previously established allocation.
Since we’ve already established when to invest, we also need to establish the idea that these transactions should be uniform. You should be buying the same stuff over and over again regardless of recent activity. If you have a system where you contribute $500 every month, but you don’t know what you’re going to buy until the money that the $500 goes in, then you’re doing it wrong. Establish your allocation, then stick to it. The more you can automate this to remove the decision making in the moment from the equation, the better.
Now, if circumstances warrant a change to your overall allocation or investment approach or if it is time to rebalance, then this is a separate process. The regular investing process should continue and reflect your overall investment approach. Changing the overall investment approach is a process that exists outside the regular investing schedule.
Timing Rule No. 3 – When a rare crash occurs, you might consider additional actions.
Rule 3a – It’s important to have a previously established threshold for what constitutes a market crash. This should be at least a 25% correction off the highs and probably more like 30%+.
The goal for the threshold is to make sure that this is not a normal correction that we see every year or two. This should be an event that only happens every 5-10 years or so.
Rule 3b – If the threshold hits, consider re-risking a bit or rebalancing toward your equities allocation.
As long as you aren’t close to retirement, a market crash is a good time to consider aggressively rebalancing towards equities. You might even take your fixed income percentage down to zero and go 100% equities. Then as markets recover over time, you might slowly move that stocks/bonds split back toward your target allocation.
Since we’re setting rules, establish these specific moves ahead of time. If your target allocation is 80/20 stocks/bond, then maybe decide that if stocks hit your threshold of rule 3a, you’ll move to a 95/5 stocks/bond split. As always, the rules can differ between investors. The key is just that you have the rules in place to guide you during various market events.
Rule 3c – If your job is secure and income quite stable, consider drawing down a portion of your emergency fund to put into equities.
Obviously, there is some risk involved in a move like this, so you’ve got to be cautious here and make sure you understand all the variables specific to your circumstances. For instance, do you have any potential expenses coming up? Are you living below your means? What would you do if you got hit with an unforeseen expense? Etc.
But, the point here is that we have potentially a very attractive window to allocate extra funds towards equity investments due to the recent large move lower in the stock market.
Note that it’s also worth saying that, in the moment, this type of move feels quite risky. You’re taking safe cash and putting it into the market at a time when nobody wants to be in the stock market. This is why planning ahead for this is so key. Your previously established strategies can overrule the emotion of the moment.
Some personal anecdotes
Interestingly we just went through a major market even with the coronavirus pandemic. As a result of the virus and the economic shutdown, the stock market dropped over 30% in March of 2020. I was extremely well positioned for a major move lower in the market with an allocation of roughly 40% equities, 30% bonds and 30% cash (the reason for this allocation is due to some fairly unique circumstances). As the market moved lower, I patted myself on the back and got ready to make my move. I wanted to exit this window of opportunity with an allocation that was something close to 100% equities. What followed was a series of moves with some being great moves and others showing how hard market timing is even when greatly prepared for such an event!
So what did I do right? In late March near the bottoms of the market, I switched all of my kids 529 accounts to aggressive allocation (they were previously set to conservative/moderate allocations). I also halted my extra payments on my mortgage, and instead began putting that chunk of money into the stock market instead. Moreover, after a huge run in Treasury yields for over an hour and a half, I sold most of this position in order to move that money into equities. I also moved quite a bit of cash into a broad index fund during the time frame from late March to early May.
What did I do wrong? Simply put, I didn’t move quick enough. The market bounced back very quickly. While I moved about half the cash position into the index fund, ideally I’d have moved all of it in. But at various times, for whatever reasons, you rationalize to yourself that things might go even lower. In the moment, it’s easy to hesitate. This is normal, because you’re essentially doing the opposite of what the masses are doing. And so, the markets are 25-30% off the lows, and as of writing I’ve still got a chunk of cash not deployed in the market. Currently, I’m sitting roughly at 85% equities, 15% cash. Compared to the 40/30/30 split from before, I’m certainly much more aggressively allocated towards equities. So, overall, a win. But perhaps not as much of a win as it could have been.
I share this example because it shows that without a pre-established plan that you stick to no matter what the circumstances are or how much noise there is, you likely won’t execute how you think you will. Overall, I’m happy with the moves I made, but had I been more particular and specific with my plans given a certain type of event, I would have been better off.
As always, the goal here is not to ensure you adhere to specific rules, but just to make sure you adhere to some kind of rules. Rules that work for you and that you establish and stick to. Write your rules down and make sure you’re operating within the pre-established framework you’re setting for yourself no matter what the market is doing.