Updated: Mar 4, 2021
When new investors decide to invest in stocks, they often think this means they must pick particular companies to invest in. They assume they should be putting time and effort into researching individual companies, understand their financial statements, and know the styles of the management team. The new investor’s plan is to do the research, make conclusions, and then invest in certain companies. Many investors take this is a step further and try to decide when the best time is to buy these stocks.
Allow me to outline efficient market theory, which should lead you to believe that picking the right stocks or perfectly timing the market involves more luck than skill.
Efficient Market Theory
The efficient market hypothesis or theory states that most information is already reflected in a stock’s price. Efficient market theory takes 3 forms: weak, semi-strong, and strong. Weak form efficiency states that investors can not look at historical trends to predict future trends in the market. For example, just because the market has increased for 3 straight days does not mean it will go up today. If investors subscribe to weak form efficiency, they believe studying individual company data can allow them to beat the market.
Semi-strong form efficiency states that all publicly available information is reflected in the stock’s price. Investors that subscribe to semi-string market efficiency believe that historical market data can not help them predict the movement of stocks. Furthermore, they believe any publicly available information about a company, including their financial statements, is useless in predicting stock price trends.
Strong form efficiency states that all information is reflected in a stock’s price. This means that individual company information and insider information are already reflected in the stock’s price.
Experiments suggest that stock markets, especially the US stock market, are very efficient.
The random walk hypothesis is consistent with the efficient market theory. It states that regardless of the past movement of stocks, they can go up or down. Stock price movements cannot be predicted.
Dollar Cost Averaging
The market clearly moves up and down constantly. Furthermore, markets react so quickly to new information that price changes are basically instantaneous. I happen to find it hard to believe that insider information is also reflected, however, there’s no real way of knowing for sure. So, I subscribe to the semi-strong form efficient way of thinking.
Because of my relative lack of sophistication and absolute lack of access to insider information, I believe in dollar cost averaging investing. The goal of this strategy is to minimize the impact of volatility by investing a constant dollar amount at consistent intervals.
Let’s use a 401(k) as an example, and let’s use very simple, round numbers. If a worker makes a $60,000 salary and puts 10% into her 401(k), she would be putting $500 per month into her plan ($6,000 divided by 12). Let’s assume she’s investing into a mutual fund and she makes the following once-monthly purchases:
As you can see, initially the worker is able to purchase 50 shares at $10 per share. During the year, she’s able to buy as many as 83 shares when the price per share is $6 in May and as few as 36 shares when the price per share is $14 in December. On average, the investor was able to pay $10 per share throughout the year using a dollar cost averaging strategy, thus minimizing the impact of volatility and market timing. Although the investor didn’t get to buy a large sum in May when the price was lowest, she also didn’t buy a large sum in December, when the price was at its highest.
If an investor believes, like I do, that the markets are efficient and the stock market undertakes a random walk, the best strategy an investor can employ is one of dollar cost averaging. Investors can put money aside and invest little by little, growing their portfolios over time while minimizing the negative impacts of volatility and ensuring shares are not only purchased at the height of the market.