Opportunity Cost: The Pitfall of Indecision
Issue 26: June 2021
Tomorrow marks the three year anniversary of me quitting my job and starting Spring City Partners. I want to thank everyone for following along on this journey! For newcomers here is a link to past newsletters.
I want to spend this newsletter talking about opportunity cost. It is something I spend a lot of time talking about with existing and potential investors. In addition to trust, timing is the biggest hurdle that keeps people from investing. Everyone wants to know if now is the right time to invest in the market. My answer is always yes AND no. To understand why, let’s dive in!
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Opportunity cost is simply the difference in value between two decisions.
The most common opportunity cost I come across is people asking me if now is the correct time to invest. My answer is always yes and no. Yes. If you have a plan and a long enough horizon, it is always a good time to invest in the market. No. Chances are every investment you make will be negative at some point in your ownership. The ability to perfectly time when to invest is not something I possess. I am a firm believer time in the market is more important than timing the market!
I decided quantify the opportunity cost taken trying to time the market. The chart below shows the percentage of days SPY declined by 25% in a given period going back to 1993. Of the 6,439 samples over a three year period, there were 411 days (6.5%) where SPY had declined by 25%. Extend the horizon out five years and those numbers shrink to 9 days (0.14%).
There are two implications from this chart. First, on average the market declines >25% once every fifteen years. Since 1993 (28 years ago) there have been three periods where the market declined by >25%: 2000-2002 during the dot-com bubble, 2008-2009 with the Global Financial Crisis, and the COVID-19 pandemic in 2020. Now all you math whizzes are probably saying, “Bill, how could it be fifteen years on average if we’ve had three events in the last 28 years?”
Simple. Each of these events proved to be transitory, highlighting how short lived steep market declines tend to be. The longest stretch was 308 days following the dot-com bubble. Between both the Global Financial Crisis and COVID-19 Pandemic, there were 103 days (3.4 months) where the market declined by >25% over a three year period. The length of the dot-com bubble decline makes sense considering the speculative excess in the market leading to the bubble.
Now we have data supporting a market decline >25% every 10-15 years. If you know when the market will decline by 25% next, please email me about a month before it happens. Thanks! Since we aren’t psychic, we don’t know when the market will decline by 25%. What can we do to analyze the opportunity cost of investing in the market now or waiting for that next decline?
Let’s assume we have $100,000 to invest in the stock market. We can invest in three portfolios with returns of 5.0%, 10.0%, and 15.0% per annum. Each year we assume our investment declines by 25%, but then continues on compounding at the various IRRs.
As you can see in the table above, you need to be confident the market will decline by 25% in the next three years to not invest in a portfolio that can grow at 15%. For a portfolio that grows at 10.0% the breaking point is four years. And for 5.0% growth the breaking point is six years.
If we go back to our first dataset, we know SPY has experienced three such declines in the last 28 years, once every 9.3 years. To keep you from investing you need to believe we will see another selloff faster than average AND returns of your portfolio will be modest.
With this being my newsletter and my entire mission being helping people reach their financial goals, let me leave you with salesman Bill. Without a plan and strategy, achieving your long-term goals will be challenging. The last twelve months have been very kind to anyone who invested in the market. This creates two key risks to consider. First, overconfidence in your ability to generate attractive investing returns moving forward. Recognize what was luck and what was skill. Second, and the thrust of this letter just because the market has experienced rapid appreciation over the last twelve months doesn’t mean it is a bad time to invest in the market. There are people out there with portfolios positioned to generate double-digit returns over the next 5-7 years. If you want to talk to one of those people, you know where to reach me.
Bill