Should you buy when the market is at all-time highs?
- The decision to invest in the share market at or near all-time highs can give investors reason to pause, but history suggests that buying at or near highs provides better returns versus waiting. The key reasons for this surprising observation include:
- Rising markets tend to keep rising – A share market at all-time highs has a tendency to keep rising over the short to medium term. There is a mountain of quantitative research that has identified this factor known as “momentum”.
- Opportunity cost – On average, markets rise over time by about 10% p.a. Waiting for a market dip can be a long wait and comes with the opportunity cost of a market moving higher before any pullback.
- Short term market movements are unpredictable – Short term market movements are just very difficult to predict. Even the Covid pandemic saw an almost unprecedented economic shock but soon saw markets bouncing to all-time highs with the assistance of fiscal and monetary stimulus.
- Missing the ‘best’ days matters – The handful of best days contribute so much to market returns. Missing these can be materially impact long term portfolio returns.
- Dollar cost averaging – Dollar cost averaging has historically produced an inferior result to investing upfront. This is the case even when tested against only investing at market highs.
- Market timing is not critical to long-term success – Timing investments into equities is not actually critical to investment success. The longer the investment horizon, the lower the chance of a negative return from equities.
- The combination of a market at all-time highs and high valuations also tells us little about what the market might do over the next 1, 3 or 5 years. Market valuation is useful in informing us about expected long-term but not short-term returns.
- Investing in cash and being ‘out of the market’ can lead to strong emotions around missing out if the market keeps rising. Few investors have the fortitude to sit on the side lines while other participants are benefiting from a rising market and investors should consider how they might react in such circumstances.
- Lastly, even if an investor successfully waits for a market pull back, these market events are usually associated with “bad news” of some sort. It can be emotionally difficult to buy when market commentary is focussed on telling you why the market will fall even further!
Why buy at market highs?
Using historical S&P 500 returns as an example, 1, 3 and 5 year returns from buying the market only at all-time highs has proved superior to investing on just any day. The tendency for rising markets to keep rising is known as “momentum” and indicates that in the short term at least, market participants are expecting better news to come.
Rising markets tend to keep rising
Dollar cost averaging is a common strategy for investors to reduce the timing risk of investing in the equity market. However, dollar cost averaging involves having part of the investment temporarily invested in cash when on average, the share market rises approximately 10% per year, or 0.8% per month. Since 1881, the 1-year return of dollar cost averaging beats investing fully upfront only 20% of the time.
Buying at highs beats averaging in
While market direction is difficult to predict in the short term, successfully waiting for a meaningful market fall can result in a buying decision that coincides with negative market headlines. The rapid market fall triggered by Covid subsequently bottomed on the 23rd of March 2020. Any reluctance to buy the market amidst the uncertainty of how the coronavirus pandemic would impact markets proved costly. By April the market had risen by as much as 31% from the March low and as much as 44% by June.
The 20 best days for the S&P 500 since 1988 provided a total return of 270%. Finessing the timing of market entry can risk missing these best days and leave the portfolio return lagging that of a fully invested portfolio.
It pays to stay fully invested!
Rules of thumb for investing at market highs
For hesitant investors seeking to invest at market highs, the following strategies can help set realistic expectations of portfolio return and minimise the potential portfolio drawdown.
- Long-term investment horizon – It’s important to keep in mind that an investment in equities requires a long investment horizon. A longer horizon reduces the chance of a negative return over that horizon. Since 1871, 97% of 10-year returns have been positive
Long horizons produce more positive returns
- Dollar cost average – While the dollar cost averaging strategy delivers lower returns on average versus investing up front, it may be a pragmatic (rather than optimal) strategy to ensure some investment is made versus the alternative of remaining in cash over a sustained period.
- Diversify! – Diversifying across regions and sectors reduces the chance of a portfolio drawdown. Global equity markets have tended to provide similar returns over market cycles so tilting to markets that have lagged can help provide downside protection and boost returns.
- Funds vs direct stocks – We recommend investing in equities via diversified funds rather than direct stocks. A diversified fund can reduce the potential portfolio drawdown vs more concentrated stock holdings.
- Investment style – We recommend considering active funds that focus on an investment style that has lagged the broader market. Investment styles such as value or growth come in and out of favour through a market cycle.
- Indirect vs direct – We recommend considering funds investing in non-listed assets where the underlying asset pricing (and NAV) may have lagged that of funds owning only exchange listed assets. Asset classes such as direct property, direct infrastructure and private equity may offer opportunities here.
Are there exceptions to buying at highs?
From time-to-time during a market cycle, elevated equity valuations imply future returns will be lower than average. However, these high valuations are not necessarily helpful in predicting near term market pull backs. Investors should consider several factors when thinking about timing their entry into the equity market:
- Equities, even at elevated valuations, may still provide higher relative (expected) returns than bonds, cash or other alternatives. For example, our forward-looking capital market estimates are significantly higher for equities than bonds even at record high levels.
Both equities and bond valuations elevated
Capital Market Estimates
- Elevated valuations can be associated with deeper than average periodic drawdowns, however the path to that drawdown is uncertain. An expensive market at record levels does not mean a correction is imminent or that it is a poor time to buy. Increasing the influence of governments and central bankers via fiscal and monetary stimulus is impacting short to medium term market outcomes.
- Deep or sustained market corrections are usually corelated with either economic recession and/or an unexpected spike in interest rates. These are the macro events that should drive caution when trying to time the market and at this stage, neither appear on the horizon.
Sourced from Macquarie Investment Update #67 – This research contains general advice and does not take account of your objectives, financial situation or needs. Before acting on this general advice, you should consider if it is appropriate for you. We recommend you obtain financial, legal and taxation advice before making any financial investment decision. Past performance is not a reliable indicator of future performance. You should consider all factors and risks before making a decision.
Director of Financial Planning