Should I Stop Investing Since the Market is Down?
Well, the market keeps going down and I keep trying to scrounge up more money to put into it. That’s pretty stupid, right? If you read CNN Money or other sites, it seems that most of the questions asked of their financial experts revolve around "should I throw in the towel and finally pull my money out of stocks and mutual funds?" or "should I stop putting new money into mutual funds until the market stabilizes?" It seems that lots of people finally get fed up in a down market and sell so they don’t lose any more and then they buy after they are comfortable the market is going up again (hopefully not when it is higher than it was when they sold).
It’s just common-sense….right?
It is just commonsense to stop buying more stocks and mutual funds while the price is falling, right? right? Well, I know it’s a bit different, but why do people get up in the middle of the night and fight the crowds to buy a big HDTV on Black Friday - because the prices are higher or because they are drastically reduced?
Of course, we buy most items when they are on sale…so why do we not want to do the same with the stock market? Have you ever heard someone say, "hey Bob, did you see that the prices of computers have been going through the roof lately, I’m gonna go buy me one!" I’m sure, however, that you’ve had someone tell you that they weren’t going to buy any more stocks until they started going up in price again (or worse yet - they buy gold when it hits a 20-year high!).
Obviously, it would be awesome if you could easily time the market and know when the peaks and valleys were so you could sell at every peak and buy back at the bottom…but let’s assume we all live in reality for the rest of this post.
Buying things for less money is good
Since the stock market has dropped A LOT in the last year or so, the prices of mutual funds are much cheaper than they were. If you do not believe this is the end-times, then you probably assume the market will recover at some point. In that case, this is actually a great time to invest more in the market. Sure, it will probably go down more, but you’re still buying shares "on-sale." So, when is the best time to invest? As soon as possible. Don’t try to time the market or wait for the perfect time, stocks prices are down so just start some regular investing.
Dollar Cost Averaging
The easiest way to invest money (assuming you can’t time the market perfectly and you probably can’t), and probably the most common, is to employ an investing technique called dollar cost averaging. Employing DCA is quite simple, you just invest a certain amount money at set intervals. If you are setup to have money automatically invested into your 401k each pay period, then you are already employing DCA. Most mutual fund companies or brokerage companies make it easy to sign-up to have money automatically taken from your banking account and invested regularly. I personally feel this is a very simple and effective way to carry out your long-term investing strategy.
The effects of Dollar Cost Averaging in various markets
I think it’s common perception that you make the most money when the market goes up. But I’d like to look at some basic scenarios to see the effect of dollar cost averaging under different circumstances. Let’s take a look at these scenarios:
1. The market is flat
2. The market goes down and back up to original level
This will be a very simple example to simply give you a feel for the numbers. I won’t be including dividends or anything like that. Let’s say that for 12 months you invest $100 each month.
Scenario #1: The market is flat with no fluctuation
This one is easy, you invest $100 each month and the mutual fund doesn’t budge. At the end of the year, you’ve invested $1200 and the total value of the shares you purchased is $1200.
Scenario #2: The market goes down and returns to its original level
Let’s say that the value of the mutual fund you are purchasing drops each month for six months and then increases and ends up at the same original cost of $50 per share at the end of the year.
| Month | Price | Shares purchased |
|---|---|---|
| 1 | $50.00 | 2.00 |
| 2 | $49.50 | 2.02 |
| 3 | $49.00 | 2.04 |
| 4 | $48.50 | 2.06 |
| 5 | $48.00 | 2.08 |
| 6 | $47.50 | 2.11 |
| 7 | $47.50 | 2.11 |
| 8 | $48.00 | 2.08 |
| 9 | $48.50 | 2.06 |
| 10 | $49.00 | 2.04 |
| 11 | $49.50 | 2.02 |
| 12 | $50.00 | 2.00 |
Totals:
$1200 invested
24.62 shares purchased
Total value: $1231.15
As a general rule, going up is good and going down is bad, right? I actually find it quite interesting to see these numbers and how it is possible to make money by dollar cost averaging through a down market that eventually rises again. Even if the market only gets back to its original level, that is certainly not the same as investing in a completely flat market. Both of these scenarios end with a mutual fund share price of $50, but we actually make an extra 2.5% because we continued to invest when the market was down. Extrapolating this, I can even devise a scenario where you can make more money in a down and back up market than than you can in a market that just goes up.
Applying this to the current market
For a person with the money to dollar cost average and a number of years before needing the money, the best thing that can happen for your long term investing success is what is happening right now: an extended and drastic drop in stock prices. As the market goes down and stays down, the same amount of money now purchases significantly more shares. The farther the market drops, the more shares you are purchasing each period (think of how many more shares you are buying with each DCA purchase compared to a year or so ago). Of course, this assumes that the market will eventually recover and start going back up…if it does, I think you will be glad that you continued to invest money when the market is down as it is now.
Repeat After Me: Do NOT Panic!
In case you haven’t noticed, the stock market hasn’t been doing so well lately. And after another precipitous drop yesterday, a lot of people are very concerned. So what is the best course of action to take under these current conditions?
There are two ways to look at the current situation
1. This is the end: the US economy is crumbling, the market will never recover, everyone will lose his/her job, and no one will have any money.
2. This is a painful but temporary disruption: things will be hard for a while but the market will eventually recover. Start by looking at the history of the US stock market - it has always recovered in the past, right? Isn’t the market higher than before The Great Depression, or the Savings & Loan Crisis, or the tech-market crash of the early 2000’s?
If you think the economy and the stock market will recover (eventually), then you should not do anything rash. It’s time to take a deep breath (maybe even stop listening to all the talking heads screaming "PANIC!") and sit tight.
Remember, the goal is to buy low and sell high
If you were going to get out of the market, you should have already done it. It’s too late to take action now - all you’d be doing is following the strategy of buying high and selling low.
If you are a long-term, buy and hold investor and you believe that #2 above is the current reality, then the best course of action is to do nothing. Actually, you might want to consider buying more now that stocks are "on sale." As of this writing, the major US indices are all approximately 40% off of their recent highs of about a year ago. If you believe they will recover, that sounds like a good bargain to me.
For a buy and hold investor, having an appropriate asset allocation is the best strategy to ride through situations like this, not jumping into and out of the market in an emotional frenzy. In fact, if you still have a number of years before retirement, the current events might even be viewed as good for you. I believe it was Alan Greenspan who stated in his book, The Age of Turbulence , that a prolonged recession early in a working career was actually good for building a comfortable retirement nest egg. That person is able to purchase many more shares of stocks or mutual funds due to the lower prices and see them appreciate when the market finally recovers.
What is Warren Buffet doing?
Warren Buffet has a quote that I feel applies very well to the current situation:
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." Warren Buffet
It certainly seems that now is a time when everyone is fearful…and as you would expect, Buffet seems to be out buying (He recently invested $3 billion in GE , for instance). Since his net worth exceeds most people’s by a few billion or so, I’d tend to follow his advice before that of all those on TV screaming about how bad everything is right now.
My disclaimer
Now, I certainly don’t know what the absolute best course of action is in the current economic climate (no one does). But I will tell you that I am following the advice I put forth here (I’m not like one of the professional mutual fund managers who have their own money investing in index funds). I have not removed any money from the market and, in fact, I just signed up to have Vanguard put a few hundred of my dollars into some of their index funds each month (and after reading about the 40% off sale…I’m very tempted to find some more money to put into mutual funds).
What about someone close to retirement?
Now, if you are close to retirement or in retirement and have all or most of your money in the stock market, then unfortunately I don’t have too much good advice for you. After a disaster strikes is not the best time to create a strategy to deal with the disaster - it would have been much better to plan for a possible economic meltdown beforehand by diversifying your assets among stocks, bonds, cash, etc.
What to do now is a much tougher question for someone who needs the money sooner. The real question is "what is the market going to do next?" Is it going to go down more? Are we at the bottom? Will it recover and, if so, how quickly? Unfortunately these are very difficult questions to answer (well, they’re easy to answer just not easy to answer correctly). Whatever course of action you decide to follow, be cautious - if you get out now, make sure you don’t miss the market as it starts to go back up or you’ll be worse off than if you did nothing now. It would be great if you could withdraw your money now and get back in at the bottom, but even the pros have a very, very hard time doing that. In fact, if you were a good enough investor to be able to do that, you would have taken your money out of the market about a year ago.
Emotion does not mix with investing
I’m really sorry that I don’t have a good answer for you. The one piece of advice I would give is do not panic or act out of emotion . If you decide to pull your money out of the stock market, do so because you have calmly and rationally decided that is the best course of action and not because all the TV personalities are screaming "panic! calamity! sell!"
As for me (someone with a number of years before retirement), I think it’s time to follow Buffet’s advice and get a little greedy.
Photo Credits: nate steinerHelp! I’m Trying to Determine My Asset Allocation
I recently transferred a Rollover IRA and some mutual funds in a taxable account to new Vanguard accounts. Unfortunately, I have not actually done anything with either account yet. The taxable account currently consists of two funds - a S&P 500 Index fund and a global equity fund - and some cash. The IRA is completely in cash.
Asset allocation is key
After some mistakes over the past few years (more on those in a future post), I have decided to go the way of ultra-low expense index funds for these two accounts (that is why I transferred them to Vanguard). The most important component of any investing plan (other than doing something) is the asset allocation plan. That is not to say that there is one magical asset allocation that works for everyone in all situations. Rather, choosing a plan for your situation and sticking to it through thick and thin usually leads to good long-term investing results. Click here to continue reading…
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