In the investing world (and in the business world as well), the formula for success is to "buy low, sell high". Due to its "instant results" nature, the stock market is like a dream come true for investors hoping to strike gold using that exact formula. Although the strategy sounds simple, as most investors (and many non-investors) know, timing the market is a tricky proposition.
Proponents of the market timing strategy point out that if you're able to correctly predict the direction the market (or a particular stock) is going to take, you're going to make much more money than people who catch a trend that's already formed. For instance, a stock that's accurately predicted as about to go up can be purchased, (or you can buy call options) and then you make a profit off the price increase. Or if you accurately predict that a stock is going down, you can sell it if you owned it, or you can short it and make money off of it while it's going down.
All this sounds great, but accurately timing the market is a very hard thing to do. And some studies suggest that it's not even that important that you try to. Meet Louie the Loser - he invested $5,000 a year in one of America's oldest and largest mutual funds, Investment Company of America, over the past 20 years. But because his timing is terrible, every year he picks the worst possible day to invest - the day the unmanaged Dow Jones Industrial Average peaks.
Surprisingly, Louie has managed to do very well. After those 20 years, his $100,000 had grown to $441,000, averaging a respectable annual return of 13.3%. Even more surprising was the fact that if he had followed that same strategy, but invested on the day the market hit its annual low, his average annual return would have been 14.9%! That's only slightly better than Louie's performance, with none of the anxiety and risk and aggravation of trying to time the market.
The reason why dollar-cost averaging is so effective is very simple. By investing a set dollar amount on a regular basis (say, $250 a month), you get more shares when stock prices are low and fewer when they are high. Over time, the strategy reduces your average cost per share, improving your chances of becoming a slow but steady winner.
What does that teach us? To put it bluntly, market timing is overrated. Dollar cost averaging offers returns that are not that far-removed from the hypothetical best-case market timing scenarios.
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