Updated: Sep 11, 2022
Imagine the following what-if scenarios:
What if you bought BitCoin at $5 and sold it at $1,000? then bought again at $165 and sold at $19,000? then bought again at $3200 and sold at $60,000?
What if you bought AAPL at $0.12 (after splits) and sold at $1.15? then bought again at $0.25 and sold at $177?
What if you bought SPY at $46 and sold at $150? then bought again at $81 and sold at 150? then bought again at $70 and sold at $475?
Following the above you would have made a huge fortune. In fact you would've become the richest person on the planet!
Instead, what usually happens! is an emotional rollercoaster. See if the below chart resonate with your actions:
A simpler version of the above looks like this:
Which boils down to this:
As you can see from the simple chart above, riding this emotional rollercoaster will lead you to buying at the worst time and selling at the worst time, which if repeated enough times it will leave you broke. The question is can you time the highs and lows of the financial markets and use it to invest wisely?
This question has been debated for many years with conclusions (usually) citing that it doesn’t work, because stock prices are unpredictable and It is really hard to stay on course when company prices fluctuate up and down even when you are right.
The data back up the above conclusion. Take this study by Charles Schwab, where they rank 5 theoretical investors with different timing profiles from best to worst over 20 year periods and found that investing immediately (whenever you have money to invest) or dollar cost averaging (adding money at fixed intervals) is very close in performance to perfect timing (buying at exact low and sell at exact high, which doesn't exist).
So given the difficulty of timing the market and the close performance of investing immediately or dollar cost averaging, it makes a lot of sense to follow one of these strategies to invest in the market without worrying about greed & fear cycle or following up the financial news. Almost all investor icons recommend investing in an index fund and dollar cost average as long as you can.
This is fine for the average Joe, but the problem is these studies don't care for the drawdown. You see most investors including all of you reading this post will capitulate when the market crashes (I have done it my self in the past), even when you know that long term you will be right. As humans, price fluctuations, and therefore how much money you make or lose on paper plays havoc with our emotions and we can't tolerate that.
Strategies like dollar cost averaging or investing immediately will suffer from the huge drawdowns (more than -50%) and the big disparity in returns depending on the time you start.
Long term the S&P500 index generate about 8% annualized returns with about 15% standard deviation, but depending on when you start you would have gone through a turbulent journey, Just look at this table of SP500 returns over different periods:
A better investing approach would be to reduce the drawdown even if it leads to reducing the profits in order to stick to the system, and as Algo Traders, we can definitely design systems that achieve that goal.
Check out the performance (log chart) for the past 23 years which includes long bear market and longest bull market plus many small corrections along the way of two systems, dollar cost averaging in the SP500 and Dual Momentum system that invest in SP500 and Bonds based on momentum. Both systems start with $2,400 and add $2,400 every January.
more importantly check out the stats of these two systems:
Not only we make more money with Dual Momentum system, but we also slash the drawdown significantly.
This is not the only system that beats investing immediately or dollar cost averaging, There are many systems that have been developed and peer reviewed on SSRN, but they just don't get enough media coverage. Here is a sample list of these systems and their performance for the past 20 years from AllocateSmartly. Notice that SP500 returns doesn't even make the top list!
All above systems trade on monthly signals so they are very slow, and they are perfect for anyone to implement, because they don't need to follow the financial markets, or invest in complicated testing platforms, or spend a lot of time researching, etc.
15 minutes a month is enough to implement any of these systems.
I have developed 3 portfolios that are available in my discord server based on momentum concept that trade on monthly signals. Below are their stats:
I have also videos on my YouTube channel that go about developing different market timing systems for active traders:
In conclusion, There is nothing wrong to start investing in an index fund, but once you gain more experience then it should be straight forward to invest in a better system to get better risk/return ratio and with the free amount of education available today there is no reason not to do so.
I don't see a reason that you shouldn't implement any of the above systems to invest instead of dollar cost averaging in an index or worse staying in cash!