Episode Transcript
Brenton: [00:00:00] Every year investors try to time the market believing they found the perfect opportunity to exit out of, or enter into a certain investment position. In this episode, we talk about the fallacy in that line of thinking and how investing with consistency can take the human error outta the investment process.
Let's get started.
Brenton: Hello. My name is Brenton Harrison of New Money, New Problems. And your host for the New Money, New Problems podcast. In this episode, we're going a little deeper into our conversation that started previously about the pyramid of investments. And now I want to talk about the behavioral elements to investing. Because one of the most difficult things to do is when you get into [00:01:00] the investment game, you feel like you don't know anything at all, and you can have this fear of dipping your toe in the water at all.
But the problem is once you get into it a little bit, you start to believe in many cases that you know more than you think you know, and it can lead to instances of trying to time the market. And this is a phenomenon that I encounter every single quarter as an investment advisor. When you have a client who reads articles or hears things in conversations, and they believe that they know that now is the time to get out of the market or now is the time to get into the market. And the funny thing about that is the majority of the time the crowd is wrong when it comes to their predictions about when to enter and exit the market.
In fact, Warren buffet has a really popular saying that says ' you should be fearful when others are greedy and greedy when others are fearful'. And that quote is attempting to describe the power of the herd mentality that says most people are gonna follow what they see the herd doing. And when it comes to investing, in many [00:02:00] cases, the herd is wrong.
So what put this at the top of my mind? If you've been following to this point, you probably have gathered that I get a lot of the ideas for these episodes based on articles that I'm reading late into the night. And this is no different. The start of the year has been surprisingly good when it comes to elements of the stock market. As a matter of fact, the S and P 500 index is up about 8% year to date. Many people have been surprised by this because there was the expectation that as a result of potentially increasing interest rates that we would be in for a rough stretch for all of 2023. But because it is outperformed, you're starting to see articles. from investment strategists about now being the perfect time to sell some of those positions that have held a gain. If you're following along with us on screen, you're looking at an article from Business Insider entitled, 'There's no reason to wait. Sell US stocks now before the S and P 500 tanks by over [00:03:00] 20% strategists say.'
And the premise of this strategist position is that the reason that stocks have been better than expected this year is because investors were believing that the federal reserve might increase interest rates, but at a slower pace. They're going to ease up on their tight monetary policy, which they're using to tame inflation. So the idea being that because they are bullish on the fact that the worst might be behind us, it has led increase in investor sentiment and thus an increase in positive returns. This strategist believes that that period is coming to an end and we have some inflated earnings amongst these companies.
So he believes that some of the negative impacts of the fact that there will still be some small interest rate increases, combined with some of the bank failures we've seen in recent weeks will lead to these levels of potentially significant losses.
Now, this person is paid to manage money all day. And I'm going to assume no matter how dangerous that might be, that he's more informed as to market [00:04:00] movements than you or I would be doing this with a more limited amount of time. And I would also hope that when he's talking to investors about the quote unquote, perfect time to exit the market, that there's an assumption on his part, that he's talking to a seasoned investor an informed investor. Someone who's taking some time to be well informed as to what's going on in their portfolio.
But in reality, in my experience, that's not how these things play out. And what happens is you have a person who is not that keyed into what's going on in their portfolio, or they are, but they have a false sense of security about how knowledgeable they are with their investments, and they make decisions based off of these types of headlines.
And in trying to time the market, they often end up with the wrong result And this is not a novel concept. I don't think it's a strange thing to say that investors on average are horrible at timing the market. And in terms of behavioral finance, there's actually a tool that you can deploy to lessen the risk that human error has a negative [00:05:00] impact on your portfolio. And that tool is called dollar cost averaging.
Dollar cost averaging sounds like a fancy term, but in reality, it's just you taking an amount of money and investing it consistently over a defined period of time. As an example, if you had $500 to invest over a five month period, instead of you putting $300 in in month, one and $200 in in month four, you would put a hundred dollars a month every single month for the five month.
Now the goal of putting money into the market in equal increments using dollar cost averaging is to look at the investment you're purchasing and hopefully bring down the average price you're paying for said investment as compared to using irregular intervals where you are trying to time the market. And you might go in or out at the wrong time.
In fact, let's use that example that I just mentioned. We're going to assume that we give two different investors, $500 that they can invest. And they're going to have a five month period in which they can invest those funds. Now let's say that they're [00:06:00] buying a stock or a mutual fund, what have you, and the value of that stock or mutual fund is going up and down throughout that five month period. As a matter of fact, in month 1, it's a hundred dollars a share. In month two it's $50 a share in month, three $75, in month four, $125, and in month 5 we're gonna assume that it goes back down to a hundred dollars per share.
Now, our first investor is not going to use dollar cost averaging. They're instead going to try to time the market and put their $500 in at the periods that they believe are the perfect times to invest. So let's assume that in month one, they put in a hundred bucks when the price of that share is a hundred dollars and they receive one share. Then they take a couple months off and in months four and five, when those shares of stock have gone up to $125 and a $100, they put in $200 in each of those months. So it's $500 that's just spread out in irregular increments. And at the end of that period, they have purchased [00:07:00] 4.6 shares of this stock or mutual fund for an average price per share of just under $109.
Now our second investor uses dollar cost averaging. They say, I have no idea what I'm doing. So instead of trying to time the market, I'm just gonna put in a hundred dollars each month for this five month period.
Now as the price of that share goes up and down, their contribution level stays the same. At the end of this five month period, they end up purchasing five shares of stock, as compared to the other investors's 4.6 shares, for an average price per share of $100, as compared to $108 and change that we saw with the other investor.
So these two investors, one of whom is trying to time the market, the other who's using dollar cost averaging, end up putting the same exact amount of money in throughout the five month period. But because of the way that the market moves, the person who did not use dollar cost averaging paid almost 10% more for the shares [00:08:00] they received, and they got less of those shares, than what you find with the person who uses that dollar cost averaging method.
Now after the break, I'll give you an example of when dollar cost averaging may not be as appropriate, but also some powerful statistics to drive home the point of using this method, when it is the right thing for your portfolio.
[00:09:00]
Brenton: Before the break, I teased that there may be some times where dollar cost averaging may not be as appropriate. And that really has to do with periods where you have the money set aside that you plan to invest, but rather than putting it in the market, you use longer periods in which you're gonna draw out that contribution.
And there's an article that I have up on screen that's entitled, from CNBC, 'Here's why lump sum investing is a better option than dollar cost averaging.' Now that's a catchy title, but really what they did in these studies is they took [00:10:00] rolling 10 year periods. And they gave two investors, a million dollars in which they could invest in each decade. One of those investors in the first year invest the entire million dollars in January of that year. And then for the remaining nine years and 11 months, they just let the market do what it does with the money. The other investor chooses to dollar cost average that million dollars into the market over the course of a year. And then for the remaining nine years, they let the market do what it does with their portfolio.
And what they found was that 75% of the time, the person who put the entire million dollars into the market in January of year one, outperformed the investor who broke up that million dollars into monthly contributions over the course of 12 months.
Now I bring this up for two reasons. The first is in trying to illustrate that there are people out there who already have an amount of money that they're willing to put into the market. And for those people, it can be more beneficial to either put that money into the [00:11:00] market immediately, or to have a dollar cost average into the market in a smaller window.
But the second reason I bring this up is to hopefully illustrate that of course it makes sense to put money in the market now, if you already have a million dollars set aside. But most people's circumstance is not that. And instead, the way that they get money in the market is by dollar cost, averaging it anyways, by contributing to accounts on a monthly basis.
And there's more research by companies like Vanguard that not only illustrate the importance of having money going into the market consistently, but also the power of automatically enrolling in accounts like 401ks and automatically increasing those contributions. And before I share these stats it reminds me of a book that I read called Predictably Irrational, phenomenal book by Dan Arielly about how irrational our mind is in spite of our best intentions. And in that book it talked about how in many European countries, the percentage of their population who are organ donors, is astronomically, higher [00:12:00] than what you find in the United States. And what they Found was that in these countries you didn't have to sign up to be an organ donor. You were automatically enrolled in the program by that country, and to be removed you have to formally opt out of being an organ donor.
And if faced with the decision of just going with the flow for something in which you've already been enrolled or opting out, many of us will choose to just go with the flow. And Vanguard's research confirmed this point. They looked at 401k providers at different companies and determined which of these companies were automatically enrolling their employees into their 401k plan versus those who had to ask their employees to manually sign up for the plan. And what they found was amongst the companies that did auto enrollment, 93% of their eligible employees participated in the plan as compared to 47% of the employees at companies who asked them to manually enroll. And they didn't stop there. Three years later they went and reassessed because they wanted to know [00:13:00] how many of that percentage that were automatically enrolled or manually enrolled were still contributing three years later. And what they found was that for auto enrollment plans, three years later, 93% of those employees were still contributing in the plan as compared to 62% of the original enrollees for companies that asked them to manually enroll.
So what many companies are now doing, is they are pairing auto enrollment plans with auto-escalation features. Which means that at whatever percentage they enroll you, say 3% or 4%, that percentage of contribution will be increased year by year, up to a certain cap. As an example, automatically enrolled at 3% with a 1% per year auto-escalation up to a cap of 10. And when you look at these numbers for companies that have both features, they are even more stunning for companies that have an auto-enrollment paired with an auto increase plan.
Nine out of 10 employees [00:14:00] not only continue with the plan. but they even increase their percentage above the auto-escalation feature that you see at the automatic enrollment of the plan. This is behavioral finance at play. The brain has a radical ability to adjust to the things that it cannot see, and one of the most powerful elements of accounts like a 401k or 403b is that they are automatically deducted from your paycheck. The money is contributed before it hits your account. And when that happens after a period of time you just simply adjust to the environment in which you find yourself and you don't feel the sting of that money. hitting your account. So whereas With accounts where you're putting these lump sums in at sporadic intervals, you might be looking at it more frequently because you put the money in and you wanna see what's been going on in the previous, few months since your last contribution. But with a 401k, it's outta sight outta mind. and you might check it two or three times a year but after 10 years, you look back and it seems like there's been this radical increase in [00:15:00] your plan or that there's some magical investment in which you've placed your funds with your company account. But in reality, it's simply the power of dollar cost averaging and automated contributions doing its Job. to make sure that Your money is working for you While you are not working. That's it. I hope this episode was a good start in telling you the importance of investing with consistency and also making sure you understand that there can only be one smartest person in the room and it may not be us.
So when we're trying to time the market and we don't know what we're doing we may be better off simply leaning on the behavioral finance tools that are there to make sure that we're headed in the right direction.
[00:16:00]
