Should I Invest Near a Market High?
When the stock market is near an all-time high, some investors decide to exit the stock market, fearing of a possible decline. Although this is a common and logical concern, historical data shows that may not be the most prudent approach to navigating markets that are near all-time highs.
When the stock market nears all-time highs, is it the best time to invest? This is a logical question that many investors face. In fact, many arguments around trying to time the market usually do sound logical. However, in practice, people have been failing at timing the market for decades.
The reason? Timing the market requires two precisely correct and predictive decisions. The first is when to “get out” of the market. The second is when to “get in.” Some professional money managers will try and sell you that they can do this successfully.
However, claiming to be able to time the market is the same as claiming to be able to tell the future, yet I’m sure most would scoff at that claim. So why, then, do investors think that when it comes to the stock market, people actually can see the future?
With that said, what are investors supposed to do when the market is near an all-time high? Should you invest? Should you wait for the market to have a correction? Here are a few things to consider.
Not the First All-Time High
Although it sounds momentous, the stock market hitting an all-time high is not much of a unique event. In fact, the Dow Jones has posted new all-time highs every single year from 2013 – 2021. This means that if you avoided investing in the market in 2013 because of the market being at an all-time high, you missed out on massive gains for the last 8 years (roughly 10.12% per year on average from January 1, 2013 to January 1, 2021).
Contrary to what most think, all-time highs are not always followed immediately by a market correction. Many times, all-time highs are followed by, you guessed it, new all-time highs. In 2017 alone, the Dow Jones hit four 1,000-point milestones for the first time ever (hitting 20,000 before ultimately reach 24,000 in the same year). In 2019, the Dow Jones hit 22 record closes.
So, each time the market hits an all-time high, it isn’t the first and likely won’t be the last time.
How much will you give up waiting for the correction?
Of course, if you had the choice to invest at an all-time high vs. at the bottom of a bear market, we’d all certainly choose the latter. The problem is that we don’t know when those bear markets will happen.
According to First Trust data that analyzes bear markets from 4/29/1942 – 12/31/2020, the average bear market decline was 32.1% and lasted 11.3 months. Therefore, if you timed things perfectly, 32.1% was the maximum average benefit to market timing.
However, selling too early in preparation for a downturn could have caused you to miss out on the “melt up” that usually happens before the “melt down.” If you sold after a bear market had started, then you would not have dodged the full 32.1%. Then, if you wait too long to buy back in, you could miss some of the rebound as well.
Because the stock market has had more good years than bad, many investors find themselves giving up more in lost gains than they protected in potential losses.
In an interesting piece of research from New York Life, we can observe that the S&P 500 (or its equivalent) has posted positive returns over 70% of the time dating from 1825 – 2020. Therefore, even investing a lump sum just prior to market correction would still have resulted in competitive gains over a long period of time.
Lump Sum or Dollar-Cost Averaging?
While it may not be a frequent occurrence, investors may find themselves sitting on a lump sum of cash and unsure of how to proceed (i.e. invest everything at once or invest portions over time). Regardless of what data shows, it seems against human nature to want to invest a lump sum in the stock market, especially if the market is near an all-time high. Many think that investing a lump sum is not prudent because of the chance that you may invest right before a major market decline.
However, research shows the opposite.
Vanguard published a study in 2012 that measured outcomes of a lump sum strategy vs. investing cash in smaller portions over time (also known as dollar-cost averaging). They found that a lump sum strategy outperformed a dollar-cost averaging strategy two-thirds of the time. Therefore, the historical evidence suggests the prudent route is investing everything at once and not bits at a time.
The decline of 2020 proved to be another notable example of how markets have recovered after major declines. Even for those that invested a lump sum on February 9, 2020 (right before the COVID-induced market crash), the S&P 500 still earned approximately 13.6% from then through February 28, 2021.
Of course, emotional factors and expected withdrawals must be considered when making these types of important decisions. If you think you may find yourself in a position where you would be unable to maintain a consistent allocation for either reason, then dollar-cost averaging might be a better route for you.
Knowing Your Time Horizon is Key
The discussion of investing when the market is near an all-time high could change drastically based on differing time horizons. In other words, the best route is likely different for shorter investing periods vs. longer investing periods. In fact, I would argue the stocks should not even be considered for short investing periods, due to the potential for short-term volatility and loss.
For most, the key to investing well should not be trying to predict the short-term, but it should be about choosing the right asset allocation mix for the long-term, which historically has been much more predictable for stock returns. The “right” allocation is made up of two parts; what fits for your financial plan and what fits for your emotional tolerance.
Allocation Based on Expected Withdrawals
In the investment industry, we often look at a portfolio’s asset allocation as a percentage of equities (stocks) vs. fixed income (bonds). For example, a 60/40 portfolio is one with 60% stocks and 40% bonds. The goal of using stocks and bonds is to add diversification. However, the purpose for this differentiated approach should go deeper than just that.
A helpful way to further dissect a portfolio’s asset allocation is to think of it in terms of different buckets; short-term, mid-term, and long-term. A short-term bucket represents your potential short-term needs (0-2 years). The investments that make up that bucket should therefore have a short-term time timeframe to match your time horizon. Good examples of this are cash or short-term bonds.
Next, you have a mid-term bucket, which may represent a timeframe of 2-10 years. Therefore, the investments used in this bucket should have a time horizon that matches that mid-term time frame. In this case, that may mean using intermediate bonds, as one example.
Lastly, you come to the long-term bucket. This bucket should be for money you will not need for 10+ years. Here, you can explore investments that have a higher long-term upside, even though that may mean more short-term volatility. And, as long as you have sufficient assets in your short-term and mid-term buckets to cover any potential needs, you won’t need to worry about having to sell anything in your long-term bucket due to a volatile stretch in the stock market.
Leaving stocks invested for a period of 10 years or more does not guarantee anything. However, if you look at performance of mutual funds or stocks over a period of 10 years, you’ll see that in many cases, the returns are not only positive, but they can be substantially higher than a cash alternative. This also supports the notion for being fully invested as soon as possible, regardless of if the market is at an all-time high.
The Bottom Line
Nobody knows when the next major market correction will occur. But, with proper portfolio construction, good investor behavior, and an understanding of your time horizon, you should be able to withstand a potential market correction with more confidence and less anxiety in the future.
Too many people think “If I could just avoid the next major correction, it will put me well-ahead of where I would have been.” The problem is with that approach is that you are more likely to give up too much upside while you’re waiting for the crash.
If you cannot remove the emotion from investing, and you cannot commit to a long-term time horizon on your equity allocation, then you should not be investing in equities. Why? There are few scenarios that are worse than panic-selling after a major market correction and never recouping your losses. In that case, you would have been better off burying your money in the backyard.
Free Retirement Assessment
We want you to know exactly how we can help before you pay us a single dollar.