“Instead of contributing $5,000 at the first opportunity [$5,500 for 2013], I would wait for a small dip because prices almost always go down during the year.
Being chicken little, I didn’t want to wait too long. So I set my limit at 2%. I took a note of the closing price that I would’ve got had I done what I always did in previous years: go all-in on day one. I set an alert based on that closing price minus 2%. If I could get in at a price 2% lower than I otherwise would have, I would be satisfied and call it a day.”
I bring this up because I often receive emails about assorted variations on this type of strategy (i.e., strategies that wait for some specific signal to buy, instead of buying as soon as possible).
Relative to other strategies that attempt to beat the market, these strategies have one big advantage: They’re unlikely to increase costs in any way. (In contrast, many market timing or stock selection strategies result in more frequent transactions, thereby increasing trading costs and taxes. And strategies based on the use of actively managed funds increase costs via expense ratios.)
Because these wait-until-[something]-to-buy strategies shouldn’t increase costs, whether or not they’re a good idea is simply a question of whether the purchase timing indicated by the signal is better or worse than buying as soon as you have the money available.
Is a High Probability of Winning Good Enough?
Given the inherent volatility of the stock market, a 2% decline isn’t very much. Such a decline is likely to happen at some point in most years. In other words, The Finance Buff’s version of the strategy has a high probability of success in any given year.
But, in itself, that doesn’t necessarily make the strategy a good idea.
By way of analogy, consider a game in which you roll a 6-sided die. If you roll a 1, 2, 3, 4, or 5, I give you $1. But if you roll a 6, you have to give me $10. This is obviously not a good game for you, despite the fact that you have a high probability of winning money on any given roll.
In the case of TFB’s strategy:
- A “win” results in an additional one-time return of roughly 2% (due to having purchased at a 2%-lower price), and
- A “loss” happens when the market marches steadily upward all year, such that the buy-signal never occurs at any point, so the cost of a loss is missing out on a year of good returns.
So, how can we determine whether the probability-weighted gains from the “wins” are likely to exceed the probability-weighted cost of the “losses”?
Reducing the Number of Days In the Market
The primary attribute of wait-for-a-buy-signal strategies is that, relative to investing the money as soon as it’s available, they reduce the number of days that you’re in the market. (For example, in TFB’s version of the strategy, the excluded period is, “days in each calendar year prior to the first decline of 2% from the year’s starting price.”) So the relevant question is whether or not the days that you are out of the market have a positive or negative expected return.
Of course, in general, the stock market has a positive expected return. Therefore, for the strategy to work over the long-term, it must be excluding days that are unusual in some way. That is, it must reliably exclude days that have not only below-average returns, but below-zero returns.
If you cannot think of a convincing reason why the particular group of excluded days would have a negative expected return, it doesn’t make any sense to use the strategy. Instead, you would want to invest your money as soon as it’s available to invest.