Can you actually hope to improve your returns based on when you buy and sell stocks, or is it just guesswork? There are three strategies that stand out to me as the most profitable: pound-cost averaging, buying on the dips and momentum investing.
Pound-cost averaging Pound-cost averaging is how every beginner investor should approach the FTSE 100. It involves putting a small part of your portfolio into the stock market at regular intervals over several years. The idea is that this will spread your risk evenly so your portfolio doesn’t suffer from market fluctuations.
Whether you like this strategy will probably depend on your personality. If you’re like me and prefer to pick stocks instead of investing in passive or managed funds, then it’s likely you’ll also want to try and find the optimal time to invest to maximise your returns. This brings me on to the next two strategies.
Buying on the dips Buying on the dips tries to maximise returns by buying when stocks are cheapest and therefore best value. Warren Buffett is the master of this strategy, and his approach is simply to acknowledge that he can’t predict the market but he can tell when an equity is below its business value. Therefore he will keep buying more as long as the price is falling and is below his target price.
This approach requires an immense amount of discipline to manage cash so you don’t become fully invested too early and also to not get scared when the rest of the market is panicking. This might sound easy, but in my experience it can be extremely stressful.
Momentum investing Momentum investing is less concerned with picking the bottom of stock market dips and more concerned with when it is rising. This approach looks to moving averages and improving confidence as the trigger for increasing the size of investments.
This approach has a significant handicap over buying on the dips which at no point tries to time the market. Buying falling equities can be painful to watch, but as long as you’re patient the market will recover and you should make a profit over time. However, momentum investing requires you to make forecasts about what the market will do in the future. This puts a lot of pressure on the investor about when they should withdraw and inject more capital.
Time in the market Two of these strategies therefore have a big advantage over the third, which is that time in the market is much more important than timing the market. One study found the difference in returns between investing at the best possible time versus the worst possible time only realised a 30% difference in total returns when investing the same amount each year over a 30-year period. All investors will end up somewhere between these two extremes so the likely difference seems relatively small to me.
Avoiding entire periods of poor performance such as between mid-2007 to mid-2009 and then investing heavily after would help returns, but there is little to no evidence that this can be achieved with foresight. The logical conclusion therefore is that you should focus on saving as much as possible and not lose too much sleep over the fortunes of the FTSE 100.
Motley Fool UK 2019