Comparing investment strategies
Written by Adam Kemp on June 13, 2016.
Imagine that I gave you $40,000 and told you to invest it for 20 years. What would you do with it?
Perhaps you’d stick the cash in the bank and keep your fingers crossed for healthy interest rates. Considering just how long interest rates have been languishing at record lows, that’s certainly not a given. It’s even possible that your money may lose value in real terms if inflation rates outstrip interest rates.
Maybe you’d immediately invest the whole lot and leave it untouched for two decades, or do you think you could try and time your investment to buy at rock bottom when the only way is up? Technically it is possible that you’d luck out and hit the perfect time for investment, although in reality it’s extremely unlikely. On the other hand, there is the risk that your timing could be dreadful and you could end up buying when the market is riding high.
Another alternative is dollar cost averaging – when you decide to invest a regular amount on a monthly basis regardless of what share prices are doing. This is an investment strategy which is supposed to reduce the impact of volatility on your purchases as you buy more shares when prices are low and less when prices are high.
Which of these choices would yield the best results?
Of course, without a crystal ball it is impossible to tell for sure but researchers have compared the results of these different strategies based on a $2,000 investment between 1993 and 2012. While there is no guarantee that past performance indicates what will happen in the future, the results are nevertheless interesting to see and the two decade timeframe is long enough to allow for the cyclical nature of financial markets.
The S&P 500 Index was used as the measure for the research. Obviously the hypothetical market timer won on the return front with a 118% return on investment but in reality no-one would be able to consistently invest with perfect timing so this really only serves as a benchmark.
In second place came the immediate investor who didn’t think about what the markets where doing but invested the full $40,000 straight away. His return on investment was 104% - not a million miles away from the perfect timer. In real terms the difference in return was only $5,354.
The bronze medallist was the dollar cost averaging investor clocking up a 99% return. Some way behind with a return of 81% was the poor timer and bringing up the rear by some distance, the cash investor made a return of just 28%.
There are a number of conclusions we can draw from this. Firstly, while cash may feel like the safest option, it really isn’t the smart way to hold your money. Secondly, as no-one can perfectly time the market at all times, the best way to invest is to do so at the earliest possible moment and leave your investment untouched as long as you can. If you don’t have a lump sum, small regular investments build up over time and can still yield a solid.
Finally, it becomes evident that the risk of mistiming investments is probably not worth taking given that the benefit of getting it absolutely right is not nearly so great as the heavy price you pay with regard to percentage return if you get it wrong (as well as being almost impossible to achieve).
If you’d like further help in deciding on the right investment strategy for you, please do contact me for a free, no obligation chat.