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When Is The Right Time To Invest?

The Dow Jones Industrial average reached a new high this month, and broke for the first time the 12,000 mark.  This is a big relief for many people that were invested in stocks and lost a significant amount of money during the bear market that started in the year 2000.  The Dow is not a very broad index, and it only captures the performance of 30 large blue chip companies.  In contrast, the Nasdaq, which contains many small company technology stocks, is still far below its high reached about six years ago. However, the Dow is a widely used index and it sets the mood on Wall Street.  Given the new enthusiasm in the investment community, the questions many individual investors are asking is whether this is right time to invest, and whether the market will continue to go up.

Is this the right time to invest?  Perhaps a more appropriate question an individual investor should be asking is "Do I ever know when the right time to invest is?"  Market timing is extremely difficult to do.  Even the professionals who dedicate their careers to this question don't get it right most of the time.  So, unless you have a crystal ball, you should not be concerned about timing your investment, which makes the question above completely irrelevant.  A long-term investor should invest on a regular basis during good and bad times.   In the long-term, you will average out the ups and downs of the market.

There is a tendency among investors to invest in the market at the wrong time.  This happens because people invest based on their emotions.  A rational investor would buy stocks when prices are low and sell when prices are high.  Yet, most people do just the opposite, they invest when they feel confident in the market, which happens to be when the prices are high.  If you have the discipline to invest during good and bad times, you will succeed in the long-term regardless of the vagaries of the market.

Consider a study done by Dalbar, a Boston based financial research firm.  The study shows that during the 18-year period between 1984 and 2002, while the average equity mutual fund returned an average annual return of 10.2%, the average mutual fund investor who invested in the same funds during the same period only obtained a 2.6% average return.  This is an astonishing difference of 7.6% return per year!  The reason why investors performed so much worse than the average returns of the mutual funds is because they bought the funds when times were good, and prices were high, and sold the funds when times were bad, and prices were low.

The history of the stock market is filled with market volatility reflecting economic and political uncertainties.  The smart investor will ignore short-term volatility and will focus instead on investing in businesses that will be worth more in the future than they are today.  The famous investor Benjamin Graham illustrated the behavior of the market with the following quote: "In the short run the market is a voting machine.  In the long run the market is a weighing machine".

Another remarkable investor, Peter Lynch, once said: "Nobody can predict interest rates, the future direction on the economy or the stock market.  Dismiss all such forecasts and concentrate on what is actually happening to the companies in which you've invested".  So to answer the first question of whether now is a good time to invest, I would summarize with another quote, this time from the value investor Shelby Cullom Davis:  "The right time to invest is when you have the money".

Now let's address the second question.  Will the market continue to go up?  I believe it will, especially if you take a long-term perspective. But you should set your expectations according to the realities of the current environment.  In the last 25 years, the S&P 500, which is an index of the 500 largest companies in the US, has returned on average 13% per year, including reinvested dividends.  This relatively high rate of return is due to the strong bull market in the 80s and 90s, before the market decline in 2000.  If you look at the market in the last 35 years, the average annual return including reinvested dividends was 10.4%, which is more in line with the long-term historical averages.

So what kind of returns should investors in the equity markets expect in the next few years?  I believe an average 10% annual return is a reasonable expectation if you don’t make the mistake of trying to time the market and if you do a good job in investing in the right companies.  The latter part should be left to professional mutual fund managers, as most individual investors do not have the time or the talent to select individual stocks.

A 10% return may not seem too exciting, but if you are able to achieve this annual rate of return, you will double your money in 7.2 years.  Achieving even this modest rate of return can be challenging in the current environment.  In order for the market to expand, either the price/earnings ratio has to increase or corporate earnings need to grow.   Both are currently under pressure, and are unlikely to show much improvement in the foreseeable future.

The price/earnings ratio, also known as the P/E ratio, is the price of the stock per share divided by the annual corporate earnings per share.  The S&P 500 currently has a P/E ratio of 16.8.  This means that investors are willing to pay $16.8 dollars for every dollar of annual profit generated by the companies that make up the S&P 500 index.  The inverse of the P/E ratio is the earnings yield, which is currently at about 6%. The earnings yield is an important measurement because it helps you compare the yield on stocks versus the yield on safer government bonds which is currently around 5%.  In other words, what yield would entice me enough to invest in a riskier investment such as stocks versus a lower risk investment such as in government bonds?  Given the current inflationary pressures and budget and trade deficits, it is unlikely that interest rates will be much lower in the next few years, so government bond yields are unlikely to decrease.  This means that the earnings yield is also unlikely to decrease, as a means to justify the higher risks of investments in stocks.  Therefore, the P/E ratio, which moves in opposite direction to the earnings yield is unlikely to expand much higher than the current level.

If the P/E ratio is unlikely to expand, the only way the stock market can go up is through increased corporate earnings.  Corporate earnings growth has been spectacular in the past several years.  According to Newsweek, corporate margins are now the highest since the 1950s.  However, going forward, corporate earnings will be under pressure due to cost increases in many areas, including raw material costs, employee health benefits costs, Sarbanes Oxley compliance costs, etc.  In order for corporate earnings to keep on growing, companies need to increase their productivity in order to offset these additional costs.

So, in conclusion, given the current economic pressures, it is unlikely that the stock market will have a spectacular performance in the next few years.  But if you invest in select companies that are able to manage their business well and continue to expand earnings, an average annual return of 10% is a reasonable expectation.

There Are 2 Responses So Far. »

  1. Hi i wanted to know when can i invest in capital market? is this the best time to invest or do i wait for markets to go down?

  2. My husband and I are new to the investing world, and have beeen looking all over the intrernet for help. We came accross an article on this website that really helped! Hope it helps ya’ll as well.

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