Why You Should Be Excited About Market Panics and Bear Markets

My 401k return this year is a depressing -3%, while my brokerage account return is +5% this year!  And they contain exactly the same index fund investments! So why the 8% disparity?  Timing!  Investing more when the market is low can make a big difference.

buylowsellhigh“Buy low and sell high”.  It’s easy to forget this golden rule of investing when the world seems to be burning down all around you.  Everyone wants to invest when we are in a raging bull market and everything is going up!  It almost seems counter-intuitive that more wealth can be created in a bear market.  Plowing money into your 401k when stock prices are sky high should be depressing, not comforting!  It is investing when stock prices are down that really creates wealth. I beat my 401k because I have the ability to “buy the dips” in a brokerage account when the stock prices are low.  I have little control over investment timing in my 401k.

I’ll excluded any individual stock return in this article, since I can’t buy individual stocks in my 401k.  Index funds will be the core discussion since it is the same in the 401k and brokerage accounts.

I like to employ a modified version of dollar cost averaging.  If you have been contributing to a 401k, you have been dollar cost averaging.  A portion of your salary is deducted from every paycheck and deployed into your 401k.  As soon as the money hits your 401k account, it is used to purchase more stocks or bonds (or however you set up your 401k investment choices).  Throughout the year you have been purchasing stock regardless of the price.  You buy it high and you buy it low, thus averaging the price.

Dollar cost averaging is a great way to put savings on autopilot and build wealth over the long term.  Most of us are not hedge fund managers working with a huge pile of cash.  We have to build wealth over the long-term by saving and investing a portion of our paychecks consistently.

DOLLAR COST AVERAGING SMOOTHS OUT MARKET CRASHES

Dollar cost averaging has actually done well over the last 15 years.  The best part is it smooths out the market crashes a bit.  Here is what dollar cost averaging at the peak of the Dot Com crash looks like: investing $1k per month for 190 months vs investing $190k at the peak.  Which one looks more stressful?   

DCA vs LumpIf you stuck with your plan during the “lost decade” (2000-2012) and kept dollar cost averaging, you came out of the financial crisis pretty okay.  It gets repeated over and over, but the key is not to panic and sell at the bottom.  Which is extremely difficult to do if your money seems to be evaporating into thin air!  So if you can’t handle volatility like this, consider allocating more to safe investments.  But don’t forget that if our investments are not growing faster than inflation we will lose money.  You will probably never retire if you only invest in ‘safe’ bank CD’s earning 1-2% interest.

It is important to note however, if you invested a large chunk at the bottom of the dot com crash you came out way ahead of dollar cost averaging.  Here is a chart investing $1k per month for 150 months vs investing $150k at the bottom of the crash.  But who the hell has $150k lying around in cash?!?  I am trying to build wealth over the long-term by consistently saving and investing; I am not trying to time the market with $150k.  That shit is playing with fire!  There is no way to know when the market will crash and no way to know where the bottom is.  If you are looking to get rich by selling your stock and waiting for another crash, you might as well go to the casino and gamble your money away.  The take away is: investing more when stocks are low builds more wealth.  Remember “buy low, sell high”.

DCA dot com crash

MY GAME PLAN

I still save and invest consistently in stocks, but when the market is really high I will save more cash and invest less in stocks.  When the market is low I will save less cash and invest more in stocks.  Instead of saving and investing a set amount, I adjust the ratio depending on stock market valuations.  The idea is that when stock prices are high, I can find a better investment elsewhere or another time, but still investing some money into stocks in case the market keeps going up!  Long live the bull market!

During a very volatile year such as 2015, my general investing plan goes like this:

  1. Max 401k and Roth IRA.  I’m investing 100% in stocks in these accounts, because the yield on bonds right now makes me depressed and there are no other good options in my 401k.
  2. Save a portion of my after-tax paycheck (I shoot for 30-50%).
  3. Invest half of the savings in an index fund and save the other half for an opportunity.
  4. If the market dips 5% I deploy a portion of the cash savings into the market.  If it dips another 5% (10% total) I deploy another portion of the cash savings.  
  5. Replenish my extra cash pile when prices are high.


bear marketWhen the market dips and an opportunity presents itself, I will dump a portion of my cash into the market.  
But not all of my cash.  It is REALLY hard to time the market perfectly and buy at the very bottom.  If I invested all of my cash in Aug 2015 when the market first dipped, I would have missed even greater opportunities in Oct.  I deploy the cash in portions so I don’t run out.

I always like to keep at least 3 months bare-minimum living expenses around in the bank for emergencies or a surprise layoff.  If you will qualify for unemployment in the event of a job loss, I feel that anything more than 3-6 months living expenses in cash is wasteful.  Some people say keep a year’s worth, but that is a ton of cash getting eaten alive by inflation.  You should be buckling down if you get laid-off anyways: no more expensive dinners, you will be eating ramen or cooking at home; no more nights at the bar, drinking water is cheaper than beer; and no discretionary spending, shopping is for people with jobs!  If you are flexible you don’t need as much cash in the bank.  Your investment income coupled with unemployment should keep you safe.

WEALTH BUILDING CAN BE TURBULENT


Worst case scenario: I invest a bunch of money trying to “buy the dip” with my modified dollar cost averaging and the market keeps crashing.  I will treat this like any other crash.  
Don’t panic and sell everything you just bought!  I am building long-term wealth and that requires holding stock for a very long time.  A drop for a year or so will seem very short if you are invested for 60+ years!  It is pretty much always better to hold onto your sp500 index fund instead of selling during a crash.sp500

THE TREND IS UP AND TO THE RIGHT

If you are not at risk of losing your job during the stock market downturn, it is a great time to be saving and investing even more!  Just be ready for a wild ride.  And remember not to panic.  Wealth building can be a turbulent process.  Even if stock prices are dropping like rocks, the general trend is up due to inflation, innovation, and population growth.  

I remember someone telling me in 2008, “I think the Dow could drop to zero!”.  Zero.  They actually said that.  The Dow or sp500 can never drop to zero.  If a company shrinks or goes bankrupt, a new company takes its place in the index.  Just like Apple replacing AT&T in the Dow.  This is how your index funds work.  You will never lose 100% of your money with a simple sp500 index fund.

As long as the fed targets 2% inflation, companies keep innovating, and the population continues to grow, you can bet the market will continue its unstoppable climb upward.  I might even see the Dow grow to 100,000 in my lifetime.

The goal is to buy these stocks for a discount and hold them for a long period of time while the dividends roll in and the companies continue to grow.  Eventually the stock price will reflect the value of the companies again.  It just might take longer than you are comfortable with to recover.  

REAL LIFE EXAMPLES OF MODIFIED DOLLAR COST AVERAGING

This modified version of dollar cost averaging keeps the “buy low, sell high” mentality and tries to improve returns by investing more when the market is low.  Most of us do not have a giant pile of cash and will be investing consistently over the long term.  Here are some investors we can relate to.  Do not focus on the numbers so much as the investing behaviors.

Meet Rick the real estate investor:

real-estate-155524_640Rick is single and makes a $68,000 salary working for a big pharma company.  He does not trust stocks as much as real estate; he prefers to invest in something tangible that he has more control over.  His employer offers a 401k program and matches up to 6%, so he only contributes 6% to receive the full company match because he is trying to save for a rental property.

In August 2011 when the stock market took a tumble, he decides to take advantage of the low stock prices; even though he prefers real estate he thinks stocks are a bargain right now.  Instead of investing the cash he saved for a rental, he just ups his 401k to the max (the max you can contribute to your 401k is $18,000 in 2015).  He uses all his 401k contributions to purchase stocks.  He is taking advantage of low stock prices with modified dollar cost averaging!   When stock prices start getting too high for comfort, he can start saving more cash to invest in real estate again.

Meet Steven the dividend stock investor:

11703097724_f503b6a495_bSteven also makes a $68,000 salary working at the same pharma company as Rick.  Steven is a big believer in the stock market and trusts companies will continue to innovate and grow just as they have historically.  Steven always maxes his 401k contributions every year to $18,000.  He saves around $10k in extra cash every year.

Steven hates the headaches that can come with managing a rental property, but wants to generate some extra income so he has been consistently saving to invest in dividend stocks.  Anytime he sees a market dip or panic, he scoops up some of the dividend stocks he has been watching.  Steven’s goal is to build a diversified portfolio of 30-40 of these dividend stocks and generate $12,000 per year in passive income.

Meet Erica who is hoping to retire early in a few years:

3702337311_5b8469551b_zErica is an early retirement hopeful.  When she thinks her finances are starting to look pretty good for retirement, the market goes schizophrenic like in August 2015.  Instead of freaking out and trading all her stocks for bonds, she keeps a cool head and starts implementing her investing strategy.  She is only 40 and is investing for a very long retirement, so she has a roughly 80/20 stock/bond split.

When the market dropped by 10% she buckled down and invested as much income as she could into her broad sp500 index fund to bring those stocks back up to 80% of her portfolio.  She is using this market drop as an opportunity to buy those stocks for cheap.  Once the market recovers and stock prices shoot back up, she can re-balance back to her 80/20 split.

CREATE A PLAN AND STICK WITH IT

The most important thing these people did was stick with their plan.  They sat down and decide: okay, here is what I will invest no matter what and here is what I will invest with my extra cash if the market drops by this much.  Creating a simple plan is the easiest way to achieve your financial goals.

Steps to create your investing plan:

  1. Determine your time horizon.  If you are 25 like me, you can be much more aggressive with stocks and learn from any mistakes early.  If you are 50 and a few years from retirement, focus on determining an asset allocation plan (like Erica’s 80/20 stock/bond ratio) by doing your own research or sitting down with a financial planner.
  2. Determine how much you will invest every month no matter what.
  3. Determine your plan when the market drops.
  4. If the market tanks stick with your plan and scoop up any bargains you find.
  5. Never panic.
  6. Get rich!

So if the worst happens, “Oh no! I invested my extra cash into the stock market during a dip and it keeps going down!” try to relax and remember the trend: up and to the right.  Keep investing like normal, follow the plan you set out, and continue to save extra cash for the next drop.  If you hold on, the relentless upward trend will bring your stocks back up, and you will be collecting dividends while you wait.  Focus on building wealth over the long term.

Readers:  Do you have an investing strategy laid out?  Have you ever found it hard to follow your strategy during the down times (when there is the most opportunity to create wealth)?  Does your investing plan include index funds, dividend stocks, real estate, or a mix of everything?

2 Comments

  1. Samantha Gordon October 20, 2015
    • Casey October 21, 2015

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