The stock market is like a daily loop of knee-jerk reactions — it goes up and down depending on news, events, and investors’ moods day to day. Trying to predict the daily ups and downs of stock prices is the first mistake many investors make.
But fear not, there is a way to build wealth in the stock market without unnecessary stress and headaches. Here is the playbook for success every investor can use.
Zoom out for perspective
First, investors need to realize that while the stock market behaves irrationally in the short term, it has proven to be more predictable over the long term. Below, we can see a chart of the S&P 500 over the past several decades.
The S&P 500 has experienced dramatic, extended declines throughout its history during periods known as “bear markets.” Listed below are recent bear markets, noted by the year they began and the losses experienced during each period. Recovering from these losses can take months or sometimes years:
- 34% in 2020
- 56% in 2007
- 49% in 2000
- 20% in 1990
- 34% in 1987
These periods were no doubt scary while they were happening. Investors probably questioned themselves and the stocks they held with many panicking and selling at low prices. But when we again step back and look at the long-term history of the S&P 500, even the worst declines are little more than minor dips on a chart that keeps trending higher.
In that context, investors should adopt a long-term mindset. We cannot control the near-term ups and downs of the stock market, but we can be reasonably confident the market will climb higher over time.
Translating mindset to strategy
Many people also try to “time the market,” waiting for the perfect time to deploy a lump sum of money to maximize their returns. It makes sense in theory, but most people drastically underestimate how hard (virtually impossible) it is to do so consistently.
Remember, the stock market is like a knee-jerk reaction on any given day — how can you predict what it’s going to do tomorrow or the day after? You aren’t much better off than just walking into a casino and putting your money on red or black at the roulette table.
The truth is, trying to time the market is a great way to mess up your total returns. If you’re waiting for a big crash to invest your money, you’ll also miss many of the days when stocks enjoy major gains. However, missing just the 10 best days in the market over 20 years could cut your returns in half.
One strategy to counter the temptation to time the market is dollar-cost averaging. You invest small amounts a little at a time. The result is a gradually growing portfolio, built up at wide range of prices that reflect the market average.
It eliminates the stressful judgment calls you otherwise have to make since you’re buying at regular intervals. A study by Charles Schwab explored how different investing strategies fared from 2001 to 2020, and it found dollar-cost averaging (DCA) produced total returns within 11% of someone who perfectly timed market bottoms every year.
The best way to follow the market
You can easily track the market using exchange-traded funds (ETFs) constructed to mimic major indexes like the S&P 500. Investing in index funds with little or no expense ratio means you avoid giving up your returns to fund managers.
A great example is the Vanguard S&P 500 ETF (NYSEMKT:VOO), which began trading in 2010. It’s constructed from a combination of large-cap and value stocks to mimic the makeup and behavior of the S&P 500. Its expense ratio of 0.03% means a position worth $10,000 in the fund costs just $3 annually. It also pays a dividend that yields 1.2% on the current share price.
If investors can’t stomach the thought of paying any management fees, the Fidelity ZERO Large Cap Index Fund charges no fees. It similarly follows a collection of the largest companies on the market, similar to S&P 500-focused funds, even if “S&P” isn’t in the name.
These low-cost funds are great tools for investors who want to utilize a DCA strategy to establish their long-term investments in the stock market.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.