Investing on Top: Seizing Opportunities or Seeking Shelter?

Sometimes, it seems like the markets are racing from one peak to another. At these times, investors may face what some call "psychological barriers to entry." They wonder if now the right time is to invest their savings in the market. After all, investing at all-time highs means paying a price no one has paid before - it creates a sense of foregone opportunities and fear of eventual regret.

Nothing New In the West

Since the beginning of 2024, we have witnessed several new records in the capital markets. The S&P 500 crossed the 5,000 point mark (as I'm writing the blog, it is already at the level of 5,230 points), the Dow Jones reached 39,000 points, we have finally seen the long-awaited recovery of the NIKKEI (Japanese index), and NVIDIA's market capitalization experienced a jump of 277 billion dollars over a single day, surpassing Meta’s advance earlier that month to become the largest one-day market capitalization gain in history.

The above data encourage speculation about strategies related to ”timing” the market. There are many who argue that the market is seriously overvalued right now and that people should get out before the next big drop occurs. Investors who decide to make such moves try to avoid the risks of a sudden drop in value and prefer to buy when prices fall.

However, it is almost impossible to precisely determine the right moment in the market, and situations in which the market reaches 'all-time highs' are not uncommon. Therefore, by trying to avoid such situations, you could be missing out on numerous potential opportunities. Even the Wall Street legend Bob Farrell, in his ninth investing rule (10 rules for investors), says "When all experts and forecasts agree - something completely different will happen". 

When we look at the statistics, it's truly amazing how much the US stock market has grown since 1950. During this period, 1,263 record values were recorded, reaching their current level. That's an average of over 18 each year. This impressive, continued value-building testifies to the long-term stability and vitality of the market, consistently providing opportunities for growth and prosperity for investors.

What Importance Do Market Peaks Have for Investors?

Recent rises in the market do not always reflect the importance attributed to them. They often result from the economy's prosperity and the growth of company profitability. Although there are periods when economic growth slows down, continued advances in productivity and innovation continue to lift markets to new heights. This can bring significant long-term benefits to investors, provided they remain engaged for the long term.

There are no guarantees with these things, but you shouldn't be afraid of new climbs. In fact, new highs are a bullish signal most of the time. Let's take a look at this JP Morgan chart:

The graph shows that if you invested in the S&P 500 on any random day since 1988, you would have achieved an average total return of 12% a year later. But it's fascinating that by investing only on days when the S&P 500 closed at its all-time high, you would have achieved an average total one-year return of almost 15%. Although these results seem paradoxical, they make sense when we consider all the behavioral biases that characterize our species.

Investors often rely on recent performance, resulting in the market underreacting to news, events, or data releases. Only when things become more obvious do investors adopt the herd mentality. This overreaction can lead to excessive movements in any direction.

Fear, greed, overconfidence, and confirmation bias can drive investors to pile into markets after prices rise or after they fall.

The combination of all these factors explains why cycles can last longer than most investors expect. There is no permanence in markets, but human nature provides a good basis for understanding downward oscillations and periods of sustained growth.

How Often Does a Major Correction Follow a Market Peak?

For those who plan to stick with their investment over a long period (which should be the most of you, as life-long investing is one of the most effective methods of building wealth) and are perhaps a little skeptical of the current market environment, it might be reassuring to know how rare it is to experience corrections after hitting all-time highs. Below are charts that visualize the frequency with which the S&P 500 has fallen by more than 10% over various time periods after reaching its highs.

Looking at just one year after each S&P 500 peak, market corrections of more than 10% occurred only 6.5% of the time. And it’s really too low probability to be worried about.

As we extend the time horizon, market corrections become even rarer. Indeed, the S&P 500 index has never experienced a drop of more than 10% at the end of a ten-year period following any of its highs since 1950. This demonstrates my previous point about long-term investment horizon being an efficient risk-reduction tool: if you invest regularly throughout your productive life, short-term market swings do not have to bother you.

When to Enter the Market

Despite these challenges, when markets are near their all-time highs, many investors feel a certain degree of discomfort when considering new investments. Some prefer to keep cash and wait for a possible significant correction before deciding to invest again. However, this expected correction often does not materialize, leaving investors with the feeling of a missed opportunity for a return on their investment.

Other important issue with timing the market is the fact that you have to be right twice. You must correctly predict the top. If you were lucky getting back to the market would be even bigger challenge. Market drops are accompanied with catastrophic projections and end-of-world news resulting in negative sentiment and emotions hard to cope with. Most people prefer waiting for the knife to drop rather than trying to catch it falling. Result is usually a missed bottom and difficulty to get back into the market.

However, as we have noted, the climax often marks the continuation of the same cycle. In the chart below, we can clearly see how our psychological nature and tendency to speculate often result in foregone profits. It shows that by missing only the 10 best days (or peaks), our returns fall by more than a half.

Source: JP Morgan Asset Management

A famous Chinese proverb says: "The best time to plant a tree was 20 years ago. The second-best time is today.” This lesson, although simple, carries a profound truth that can be applied to many aspects of life, including investing.

When it comes to investing, especially for passive investors, it is crucial to understand that the timing of entering the market should not be a source of concern or doubt. Instead, we should focus on our investment horizon and diversifying our portfolio.

In a world full of catchy headlines and quick tips, it's important to look at the bigger picture. Investors are often faced with a multitude of opportunities and challenges, but the key is to remain calm and carefully consider each move. Regardless of how challenging the current market situation may be, long-term investors will ultimately profit from the increase of economic prosperity and productivity, although their paths will be marked by many ups and downs in the meantime. The history of investing provides us with plenty of examples that confirm that optimism is well founded. Therefore, despite the challenges and obstacles, the future of investing remains bright and full of opportunities!