Although equities have delivered the best long-term track record of any major asset class, the past few years have created some anxious and frustrating moments for investors. During the credit crisis that began in October 2007, the MSCI World Index dropped as much as 57% from its peak. Then, from the trough in March 2009 through the end of 2010, it skyrocketed more than 90% as the economy improved and corporate profits made an impressive comeback.

Sadly, many investors missed out on the tremendous market rebound. The pain of recent losses, coupled with fears that the worst wasn’t over, caused them to move to the sidelines, resulting in unprecedented transfers into cash and bonds, which they perceived as being safer than the stock market.

Numerous academic studies show that our natural human instinct to avoid pain frequently causes us to choose the path we believe offers the least likely exposure to harm—often to our detriment. Our desire to minimize loss plays a significant role in decision-making when it comes to investing and can impair our ability to accumulate wealth. For instance, even though the average investor has a long time horizon and a need for growth, the tendency is to avoid stocks if it appears that a period of market weakness lies ahead. Unfortunately, one’s perception of the future is heavily influenced by recent experience, which may lead to “rearview investing.” This can result in jumping out of the market after a damaging loss (selling low) and hesitating to reenter until confidence returns (buying high).

Now that stocks have doubled from their recent lows, many are asking if this is a good time to get back into the equity market. Though no one can accurately or reliably predict the future, in this paper we will explore some important considerations in response to that question.

The difficulty of market timing

History and research tell us that it’s impossible to time market movements with any degree of accuracy. That is why we strongly believe in building an appropriate long-term asset allocation based on an investor’s time horizon, risk tolerance, risk capacity and financial objectives. Retreating from the market at just the wrong time, or being out during spurts of strength, can be costly, suggesting that investors are often best served by staying the course through short-term fluctuations. As shown in Figure 1 above, a dollar invested in the stock market in 1926 would have grown to $2,976 by the end of 2010, despite all the damaging bear markets along the way. Missing just the best 4% of months during that period would have lowered your ending value to $17.47, less than the $20.55 you would have earned by investing in U.S. Treasury bills.

Some investors believe certain economic signals correspond to market declines. To test this thesis, we looked at a broad range of economic environments in the postwar period, beginning in 1946. Over that time span, we found that stocks made money in 78% of the rolling 12-month periods, including both weak and strong environments. We then looked at more challenging times, such as when inflation was high, gold prices were surging or unemployment was elevated. Surprisingly, we found that the equity markets overwhelmingly delivered positive returns even during these tumultuous periods. As Figure 2 illustrates, only recessions seemed to have a reliably dampening effect on stocks, but to avoid those periods, investors would have needed to know that economic downturns were on the horizon before they hit.

We also looked at whether there have been reliable patterns of strong markets following on the heels of weaker periods. Figure 3 below highlights the frequency of various ranges of market returns over the same postwar period. While double-digit losses occurred in 11% of the 12-month periods, gains of more than 20% occurred far more frequently—nearly one-third of the time. After a year of double-digit declines, the market rebounded admirably almost half of the time, delivering a return of 20% or better. However, a second year of double-digit declines struck in about 25% of the cases. With that kind of bifurcated outcome, it’s no surprise that investors can’t rely on recent market behavior to reliably predict future results.

Options for adding stocks

If your current allocation to equities is lower than your target, you may be considering the possibility of increasing your exposure to stocks. But should you boost your allocation to equities all at once, or is it better to systematically reinvest through dollar cost averaging (DCA)? And if DCA is the right choice, over what time period should this technique be employed? As with any investment decision, both the choice to engage in a scaled reentry and the selection of a timeframe over which the process is accomplished must be carefully weighed.

Dollar cost averaging refers to making systematic investments into the market over a given period, normally ranging from three months to one year. Because equities rise far more often than they fall, the odds are stacked in favor of immediate investment. However, if avoiding short-term pain and disappointment is a primary objective, DCA may be a prudent compromise to putting it all in at once.

How best to “average in”

We examined 65 years of equity index data to estimate the range of outcomes one would have experienced in the first year after initiating a stock market investment under several different scenarios: investing a lump sum of cash immediately or spreading it out evenly over three, six and 12 months. As you can see from Figure 4, the potential rewards were much greater when the funds were invested more quickly, but so was the risk. During the very best 12-month period for the market, a lump-sum investor’s return would have been 56.6%. However, a lump-sum investor would have experienced a loss of 45.3% had the investment been initiated at the beginning of the most challenging 12-month period evaluated. Three- and six-month DCA would have reduced the potential upside, but would have provided essentially no downside improvement over immediate investment in the most damaging markets. Only when DCA spanned the full 12 months would there have been any noticeable downside improvement, with the lowest return coming in at –35.1%, a 10 percentage point improvement over investing a lump sum. This relative safety comes at a price, however, because the 12-month DCA investor would have achieved a lower return than the lump-sum investor in both average and robust markets.

To break this down further, Figure 5 shows the frequency of success for various dollar cost averaging alternatives relative to immediate investing. You’ll note that DCA rarely does better than lump sum investing in rising markets, with the slower approach (12-months) being more advantageous only 16% of the time. This is not surprising given the simple fact that cash kept on the sidelines reduces results in average or stronger markets. Conversely, that same slower (i.e., 12-month) approach has proven superior 88% of the time when markets were weak.

Because most investors have time horizons longer than one year, we extended our analysis of the results achieved in the very best and worst stock markets and found that the final outcome is far more impacted by what happens over the next four years than by what occurred in just the initial 12 months.

This is a great reminder that the most important decision regarding whether and how to increase your exposure to stocks comes down to your long-term wealth accumulation goals, risk tolerance and risk capacity. If short-term fluctuations create undue anxiety, a 12-month DCA approach might reduce your discomfort. But if you are willing to take a longer-term view, putting cash to work faster improves the probability of better overall results.

A balanced approach

Our discussion thus far has focused exclusively on stocks, ignoring the fact that a typical core portfolio includes a mix of stocks and high-quality bonds. A balanced approach combines assets that don’t move in lockstep, with bonds often providing a nice offset to equity market dislocations. A traditional allocation of 60% stocks and 40% bonds would have helped to deliver protection during tough periods for stocks. So while the question remains whether now is the right time to reenter the equity market, keep in mind that a balanced portfolio can assist in providing meaningful downside protection, with or without the need to utilize DCA.

Concluding thoughts

Though short-term market volatility can be disheartening, the rewards of equity investing over time have been compelling. An investor’s primary goal should be to establish a prudent long-term investment policy that can be sustained during the most challenging markets. While many investors implement their intended allocation immediately upon establishing the appropriate strategic mix, for those with a lower emotional tolerance for short-term volatility or a heightened perception of risk in the market, a dollar cost averaging approach may be the best solution for achieving one’s targeted equity allocation. n

Figure 1: Hypothetical value of $1 invested on December 31, 1925. Results reflect the reinvestment of dividends, interest and other earnings and exclude fees and taxes. Calculated by Capital Group Private Client Services using data from Morningstar software products, ©2011 Morningstar Inc. All rights reserved. Used with permission. Past results are no guarantee of future results.

Figure 2: Inflation – Source: IA SBBI U.S. Inflation Index; Time period: 1946–2010; Deflation – Source: IA SBBI U.S. Inflation Index; Time period: 1946–2010; Gold – Source: S&P GSCI Gold Spot; Time period: 1977–2010; Unemployment – Source: Bureau of Labor Statistics; Time period: 1948–2010; Federal Funds Rate – Source: The Federal Reserve; Time period: 1954–2010; Recessions – Source: Bureau of Economic Analysis; year-over-year decline by quarter; Time period: 1947–2010. Past results are no guarantee of future results.

The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. Results calculated using data from Morningstar Inc. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2011 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.