Ask the Readers: Is Now a Good Time to Buy Index Funds?
Published on - January 25th, 2008 (by J.D. Roth) A shaky stock market makes people nervous. Naturally, they’re scared of losing money. Alex, a reader in the U.K., wrote to say that he’s finally ready to begin investing, but he’s not sure that now is the time to do so. Should he wait?
I recently switched jobs to one that pays me better (and makes contributions to a pension!). My current savings are healthy enough to be considered an emergency fund; if I lost my job tomorrow and tightened my belt it would carry me through a couple of months of unemployment. I am 23.
I have never been so financially rosy, and I am certainly rosy enough to start investing. You’ve convinced me that index-linked funds (I’m talking about the things that track the stock market) are the way to go — a decent balance between risk and reward. But as we all know, things have been a bit rocky on the stock market lately.
Should I be investing now in a kind of buy-it-cheap kind of way, and accept that ‘plummeting prices’ just mean a loss of 1-2% that will be made up for in the long haul? Or should I wait a couple of months and keep that money in my current account, and make an investment in the new year when things are a little less volatile?
Alex is hoping to get some U.K.-specific advice. Because I’m unfamiliar with foreign markets, I’m going to use the U.S. stock market in my examples. I welcome comments that apply to all markets.
The short answer is: nobody knows what the stock market is going to do, and all attempts to guess simply amount to market timing, which is what the experts warn against. There’s a significant chance that the market will drop more than just 4-5% during the next year — it could drop 10-20%! But history has show that with time, the market will increase.
Looking at QQQQ, an exchange-traded fund that tracks the NASDAQ index, you can see that the share price tumbled 15% this month. But the price is still nearly double what it was five years ago. The market is volatile. Prices swing up and down. Looking at short-term history is baffling. But looking at the long term shows a general pattern of growth. Pay attention to the long-term — the short-term will only cloud your judgment.
For myself, I’ve decided to trust the advice I’ve read over the past few years, advice that says if I make regular investments in index funds, the value of my money will increase with time. 
It may not always increase — in fact, it may see some significant declines — but it will generally increase.
Indeed, when an index fund declines in value, it doesn’t bother me. I look at it as an opportunity for me to buy in at lower cost. But if an individual stock declines by a similar amount, I get very nervous. An individual stock is not diversified — if it drops, there are no other stocks there to buoy its value.
If you’re worried that the U.S. stock market faces a rocky future, consider tucking some of your money into index funds that track foreign markets. For example, I have money in EFA, which is an exchange-traded fund that tracks European and Asian stock exchanges. (EFA is not the only option — there are other index funds of this sort. It’s simply the fund that I decided worked well for me.) But be aware that foreign markets have their share of declines, too. This month, both QQQQ and EFA are down sharply.
Ultimately, only Alex can answer this question for himself. Only he can decide whether now is a good time for him to buy index funds. But my own answer is that every time is a good time for me to buy index funds.
Yesterday’s issue of USA Today featured a story called “Where’s the Best Place to Plant Your Money?” Here are some related articles from the Get Rich Slowly archives:
- What if the stock market makes you nervous? (This article includes links to risk-tolerance quizzes.)
- What the stock market decline means for you
- Saving and investing: What is a stock market index? (a video presentation)
- Intro to mutual funds: Index funds (a guest post from Vintek)
What about you? When the market’s down, do you get cold feet? Or do you view it as an opportunity to buy? What’s your advice for a new investor like Alex?
Updates: In the comments, Brad makes a very important point: “The crucial issue in making this decision is your time horizon. If you’re investing for retirement and you’re young, that’s a totally different ball game than if you’re investing to make money this year or next.” My comments above apply to long-term investors.
Here are two other video presentations related to this discussion. The second presentation is particularly important — the linked page also includes graphs demonstrating how time mitigates market fluctuations.
- Saving and Investing: An Introduction to Dollar-Cost Averaging
- Saving and Investing: The Impact of Time — READ THIS!
All of the videos I’ve linked to here are from Michael Fischer, whose Saving and Investing is an excellent introduction to the subject.
This article is about Ask the Readers, Choices, Investing
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“Personally, I lean toward making lump sum purchases at the beginning of the year *especially* if the market has fallen 10% recently.”
If your horizon truly is long term, then annual contributions are cost-averaging. You will buy in up years and you will buy in down years. Over time the cycles will average out. The monthly ups and downs of the market won’t matter much.
What is important is a disciplined approach to averaging out your investments. Because the psychology of the markets works against you. You will tend to invest when the market is doing well and wait when its not. That means you are buying high.
In this case, there does not appear to be a clear investment horizon. Outside of retirement, a lot of us save for the “future” without a clear plan for how the money will be used in the future, or when. In those circumstances I think putting some of the money, “for the long run” into a balanced index fund makes sense.
That money could be invested in a lump sum now, but because the horizon is unclear you might want to assume it is somewhat short. That means averaging investments over the course of the year is probably a better approach. If you invested a lump sum at the top of the dot.com bubble, you would still not be even. But if you invested monthly over several years before and after it popped, you would be ahead of the game now.
The bulk of savings ought to go into CD’s for money not needed immediately and/or a money market account that can be dipped into short term. Then transfer money out of those accounts into the index fund on a monthly basis.
The thing to remember is that investment horizons are often fungible. If the market does well, you an buy that new car. If it doesn’t, you can drive your clunker a couple more years.
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This looks like a fairly dated article, but I wasn’t sure where else to ask this. The standard advice seems to be for people to invest in a low-cost index fund, but what if you already have a work-sponsored account and you can’t afford to make worth-while contributions to both your work-sponsored account AND an independent mutual fund. For example, my work provides us with a Simple IRA. Those are pre-tax dollars that are taxed only when I retire and take the money. My employer doesn’t match, but they contribute a fixed percentage of my annual gross salary. I’m currently maxing out what I’m allowed to contribute to my Simple IRA, but I’m also considering starting a mutual fund, perhaps with Vangard, E-Trade, or Zecco. I don’t think I can swing both though. Any advice is appreciated.
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Dustin,
Do you have a set amount of funds in your Simple IRA that you can invest in? If so, you could invest some of your money in a Traditional IRA instead. You can open a Traditional IRA with any mutual fund company, so choose the one you like that has the lowest cost funds-I use Vanguard. A Traditional IRA will be tax-deductible just as your Simple IRA is, but you will be able to invest your money in a greater range of funds.
Or, look into a Roth IRA. The difference here is that the contributions to a Roth are not tax-deductible now. If your nominal tax rate is 15%, then you would only contribute $85 to your Roth IRA for every $100 you redirected from your Simple IRA. The other $15 will go to the IRS so that you can keep the same net take-home pay you have now. The Roth is not taxed in retirement because you prepaid the taxes.
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Dustin,
Dan makes a good point: how many investment options do you have with your Simple IRA? If you do not have many *good* choices, I would recommend investing all your funds outside the Simple IRA via either a Traditional or Roth IRA, where you can invest in low-cost index funds.
I am not comfortable suggesting whether a Traditional/Roth IRA is better for you, since the decision should be based on more information than you’ve given (age, income, marital status, current retirement account balance, retirement needs, etc.).
HTH,
Josh
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Thanks for the replies gentleman. I’m 27 by the way.
I work for a really small company, so American Funds only offers a small and relatively crappy list of investment options. We only have four or five products to choose from. There’s always been this nagging suspicion that I would be better off putting my money in an account of my own choosing, rather than what my job is offering. Especially considering that we’re so small, and I doubt they can afford or even qualify for some of the better employer-sponsored products.
One thing I do like about my Simple IRA is that it lowers my taxable income. The more I put in the IRA, the more advantageous that becomes. Another kinda nice thing about it is that (I believe) if you take the money out before retirement, for some very specific reasons such as purchasing your first home, you don’t get taxed on it at all. Not sure if that’s something I would actually do though, I’m not even close to being in the market for a home. I live in San Diego and housing is ridiculous here.
I just don’t know if the tax breaks are worth putting my eggs in that particular basket. I don’t have any specific numbers to work with at the moment, but I’m nebulously considering what the tax rate and inflation will be like when I’m at retirement age, which will be around the year 2042. Jeez that sounds like a long time…anyway I think I basically need to get at least a general idea of how much I stand to save in taxes, plus earn in interest with this Simple IRA. Then I need to look at some other options, like a Roth IRA or some other low-cost index fund, and compare. I’m too new to all this stuff to immediately know if one rout is better than another, so I guess I need to do some research.
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Dustin…
I worked for a large Company and our choices were abysmal… And I couldn’t take my money out till I left the Company … It was my gut feeling that the Company received some form of kick-back, because there are several no-fee IRA programs out there.. So why force us to live with such bad choices. We had about 12 funds and only one ranked a Morningstar 5 star rating… And that was a bond-fund, which really returned nothing each year…The others ranked down to a one star rating. I chose the best two I could and suffered along.
I now have a self-directed IRA and am much more successful. I was with Scottrade which was acceptable, and went to Etrade as they offered a really comprehensive banking and IRA/brokerage package.. After 4 months I am in process of leaving them and have set up with Wamu for banking and TD Ameritrade for my brokerage and IRA.
One thing you can do for free is to go to the Morningstar site and type in each of the funds that you have available and check them out for ratings, risk and returns. If they are as bad as my prior Company choices, then go out as I did… You will have a **world** of fund, ETF and stock choices.
Also, re IRAs and home purchases, check out this site (Bankrate.com)
http://www.bankrate.com/brm/itax/tax_adviser/20060217a1.asp
You can withdraw up to $10,000 for qualified acquisition costs of your first home and not pay a 10-percent, early withdrawal penalty on that amount. (Course, they don’t mention whether or not the State feels the same…. )
Thx jegan
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Dustin,
If, for example, you are single and earn $50,000 in 2008, then you’re marginal tax rate is 15%. This means you only reduce your take-home pay by 85 cents for every dollar that you contribute to the Simple IRA. You would get the same tax benefit contributing to a Traditional IRA, though this benefit begins phasing out if you are single and your MAGI exceeds $52,000.
Now the Roth. As long as your MAGI is $99,000 or less, you can fully fund a Roth IRA. The 2008 limit is $5,000 for someone your age. So, if you decrease your contribution by $5,882, you will owe $882 in taxes and have $5,000 available to fund your Roth IRA. The money in the Roth, including gains, will not be taxed when you withdraw it in retirement.
You can open a Traditional or Roth IRA with any of the companies you mentioned previously and you have near total control of what you invest in: stocks, bonds, mutual funds, options, futures. There is even a provision for using IRA funds to buy investment real estate, though I wouldn’t personally do it.
Just a piece of advice, don’t view your IRA as a piggy bank that you can withdraw from if you decide to buy a house or send your child to college. The money is there so you can stop working at some point. That said, Roth IRA contributions can be withdrawn at any time for any reason without tax or penalty.
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Thanks for the tips, guys. I was talking with a work colleague yesterday about this (he has the same fund I do) and it was interesting to hear his perspective, as he is in favor of the Simple IRA we have through work. His argument was that if you were to invest $1000 pretax dollars into a Simple IRA, even at a slightly lower APR of, say, 1.21, you would still earn more than investing the same amount, which would only come out to something like $800 after taxes, at a higher APR, like 1.25. He said you would have to get an unrealistically high interest rate on a different investment to come even close to what you make off of those extra pretax dollars in the Simple IRA.
He did some quick calculations and expounded it over a few years to make his point, then went on to say that his maths didn’t even include compound interest. It made sense when he said it, and I couldn’t argue with is logic.
Is this the sort of thing that’s a matter of opinion, or is this something where there is a clear-cut BETTER way of investing my money? I guess I should have asked that from the start.
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if you can afford to make your whole investment as soon as possible instead of spreading it out over a year you’ll get an extra 6 months of returns on the money you invest.
People tend to look at buying stock as a “savings” account. But I think that is mistaken. If you buy stock shares now at a higher price than they will cost you in six weeks, you will never recover that loss because you will always own fewer shares than if you had waited to make the purchase.
So if you are putting money into a savings account – now is always better. But with stocks that isn’t true. Putting money in annually is a form of cost averaging. But it will not deal with the ups and downs of a volatile market like we are currently in. If you bought stock with all your savings late last year, you are now missing out on buying at significantly lower prices. The point of cost-averaging is to even out those bumps and get shares at prices that on average approximate their actual long term value, rather than reflect some short-term volatility in the market.
Because no one is smarter than the market, no one knows whether is will go up or down. But past experience says it will go up and down over the course of the year and you don’t want to risk paying premium prices for your shares by buying them only while the market is up.
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Dustin, remember that you’ll eventually have to pay tax on the $1,000, so it becomes a wash if tax rates and return rates are the same. The only clear-cut answer is that investing more is better. Investing more will allow you to reduce your risk and still meet your goals, increasing your overall probability.
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Ross, it is true that your shares may go down in 6 months. They may also go up, in which case you’d never recover the gains you missed while waiting to invest.
Look again at your last paragraph. You said “..no one knows whether it will go up or down…it will go up and down.” Apply your principle, you don’t know whether you’ll be buying low or high. The great thing about the market is that it is not low or high, it is always at the right price for that moment. And history has proven that an investment in the market will grow, as long as you hold long enough. Even an investment the day before the stock market crash of grew considerably over the following 30 years. The right time to invest is as soon as you get the money to invest. If you want to spread it out over a few months, go for it, but don’t be one of the spectators who just sit on the sidelines waiting for the right time.
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Apply your principle, you don’t know whether you’ll be buying low or high.
Precisely. If you divide your investment and invest it in twelve separate monthly installments you will reduce your chances of buying either all high or all low. Cost averaging is a risk reduction strategy.
The right time to invest is as soon as you get the money to invest.
Any money you invest today instead of a month from now is essentially short term speculation that the market will go up. If it it goes down, you will lose money on every share you bought.
On the other hand, if you invest half now and half later, you will lose money on the first half, but you will be able to buy more shares at the lower price later.
Of course if the stock goes up, you will be able to buy fewer shares. But either way, you end up with stock purchased at the average of the two prices.
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Yes, technically, choosing to invest today instead of a month from now is a speculation that the market will go up. So is choosing to invest one month from now instead of 2 months from now. When do you lay that ideology aside and actually invest?
I personally don’t care what happens to my portfolio next month. I don’t even check it every month. All I care about is my return over the next 35 years. This month versus next month doesn’t even come up on the radar. I invest in broad market index funds and try to rebalance annually.
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I personally don’t care what happens to my portfolio next month.
If you buy at a peak in the normal cycling of ups and downs you will never make up for it regardless of how long your investment horizon. If you can only buy 10 shares at their current price and and 11 shares at the average price over the next year, you don’t ever recover from that short term speculation. You will have 10% less money at the end of whatever investment horizon you have because you will own 10% fewer shares.
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