You Need Time on Your Side for Compounding to Work Its Magic.
Too many song references in the title? . . . Anyway, in a previous article, I explored compound interest and how amazing it can be for your investments. In that article we discovered an example where you could choose to receive $25,000 each day for a month. Or, if you understand compounding, you can choose to start with a penny the first day, but then double your money each day after that for a month. It may seem impossible, but if you chose the penny doubling each day, at the end of 31 days, you’d have over 10 million dollars!! That’s an investing strategy I can get behind!!
Also in that article I also explored the differences between various interest rates and time. As it turns out, time is the most important factor when it comes to compounding. This is what I want to explore even further. But first we need to discuss two basic investing strategies.
Bottom-line! There are two investing strategies: buy-and-hold, and buy-low-sell-high.
When you think of Wall Street, you are probably thinking of a buy-low-sell-high strategy. Those financial gurus are trying to figure out which company is going under and which is on the way up. They spend their days analyzing the balance sheets of thousands of companies in order to determine which companies’ stock is overvalued or undervalued.
They sometimes will hit it right and make out like a bandit. Other times they do well managing various mutual funds and keeping things above water. It’s all about the volatility and excitement. They thrive under pressure (if the movies are accurate ;-)). In any case, this buy-low-sell-high strategy is basically trying to time the market. You have to know when to get in, and when to get out. Or like Kenny Rogers says, “Know when to walk away, know when to run.” Just like the song, this strategy is akin to gambling – with perhaps some more educated guesses thrown in.
This is a strategy that is better suited not to the common man (like you and I), but to the stock brokers and traders of Wall Street. We would better off holding to a buy-and-hold investing strategy.
So What is a Buy and Hold Investing Strategy?
Just like it sounds, you buy a stock, index fund, or mutual fund and hold it for some lengthy period of time. Depending on what you purchase, you earn money through dividends or perhaps interest (through bonds). And you don’t actually lose money unless you sell that fund for less than you paid. But if you held to this strategy, and you should, you wouldn’t sell, you’d simply hold. . . . for years. Remember the compounding effect of time.
A variation of this strategy is known as dollar cost averaging. The main proponent of this buy-and-hold strategy is that you continually buy funds or stocks using the same amount of money each time. It doesn’t matter what the market is doing. When the market is hot, you buy. When the market is tanking, you buy. Over time, buying during these ups and downs will average out your returns.
One reason this strategy is popular is that it’s easy. We all like easy. You only have to do some up-front research on the funds that you initially buy. And then you can continue to buy them month in and month out using your dollar cost averaging. And once a year or so you can rebalance your portfolio into other researched funds. You don’t have to worry about the market or whether you should get out. Because you’re in it for the long haul. Buy, Buy, Buy . . . baby buy, buy, buy.
The Advantage of Buy-and-Hold, or Dollar Cost Averaging.
Another reason this strategy is popular is that it utilizes the power of exponential growth, or compounding, to the fullest. Imagine that in the penny doubling scenario, you were excited by the growth you experienced up to day 20. Your penny is now worth over $5000. So you decide to take it out just in case the market tumbles. It can’t always go up, can it? You think that you can “time” the market just as well as those day traders.
After three days, you realize that nothing is happening, so you put your money back in the market. No harm done . . . right? It will still continue to compound, and you only lost 3 of the 31 days.
But . . . at the end of the 31 days, instead of over $10 million, you have only $1.3 million. Not too shabby, but a far cry from the 10 million you would have had if you would have left your money alone to compound. For the three days of compounding you missed out on, you lost over $9 million dollars!!!
Now I realize this is an extreme example, because no investment that I know will double every year for 31 days, but the principle is sound. Imagine that the days are years, and that instead of doubling, you can earn 10% in the market. But in order for compounding to work, you have to leave your money invested.
And before we abandon this scenario entirely, think about this. According to a report by a Boston Research firm Dalbar, if you were to have kept your money invested from 1995 to 2014 in the S&P500, you would have earned a 9.85% annualized return. This includes the keeping your money invested during the dot-com crash of 2000. But, if you were to miss the 10 best investing days of those 20 years, because you were trying to time the market, your annualized return would only be 5.1%!!!
For the everyday person who is trying to save and invest for retirement or other financial goals, a buy-and-hold investing strategy will serve them better than trying to time the market. Without the time and know-how to research different funds and stocks, it becomes a losing game.
If, instead of dollar cost averaging, you try to time the market, you will most likely be wrong. Acting on emotion and gut feeling may work for Warren Buffet, but you and I need to simply buy, buy, buy, and hold. Let compounding take over, and work for you, instead of against you.
Do you have an explicit investing strategy or are you just winging it? What do think of dollar cost averaging?
Let me know in the comments, and thanks for reading and sharing.