You’ve probably heard that you should BUY! BUY! BUY! (*NSYNC voice) your stocks right now since the market is down. On the surface, this doesn’t seem to make any sense. Investors are losing money, so why should you put your money into something that is decimating others’ fortunes? I’m here to give you the DL.
I am a believer in the Efficient Markets Hypothesis. This hypothesis says that the market price of a stock reflects all of the available information about that stock. Basically, the market price is a correct reflection of all of the available information on the company, and unless you have insider information, you won’t be able to beat the market.
Warren Buffet is an example that this assumption is not always correct. You can find stocks that are undervalued and buy them at a low price. Later when the price goes up to reflect to true value of the company, you will make money and beat the market. So while it is possible to beat the market without insider info, it is only possible if you dedicate all of the time that Warren Buffet has to finding undervalued stocks. And even most of the financial advisors and fund managers who dedicate this amount of time, produce an average annual return on their hand selected funds that is equal to, or less than the average market return over the long term. If trained professionals rarely beat the market, and Warren Buffet is either the only billionaire investor you know by name or one of a few, my guess is that you will probably not be successful using this investing strategy.
So then the question becomes, how can you maximize your returns if you can’t beat the market? I have good news. The market, on average, goes up over the long term. There will be short-term peaks and valleys, and when stocks start to dip, investors’ instincts are to sell before they lose more money. But if you’re playing the long game, which I suggest you do, this makes little sense.
I’m 30, and I do a quarterly review of my financial situation. Each quarter since I’ve started doing this, my investments and net worth have gone up…until my April 2020 review. The coronavirus has caused me to lose money on my investments for the first time in my life. But unlike many others, I didn’t sell off any of my investments and I’m not worried about them.
Unless you are near retirement, this dip in your investments is only a paper loss. A paper loss means that when you look at your account, the funds in your account are less than the amount you invested. If you withdraw the money, this becomes a real loss. Here is an example. Q1 2019 you invested $100. Q1 2020 you had $90 in your account. So after 1 year $10 is your paper loss amount. If you withdraw the $90 from your account, this loss will become a real loss of $10. Instead, you can leave the $90 in your account and wait for the market to improve over time, since as we learned earlier you should receive a positive return on the market over the long term.
On average, the market’s annual return before adjusting for inflation is about 10%. So in 5 years, your $90 should become about $145. This means you will have a paper gain of $45 above your initial investment of $100. While you will have to wait longer, if you withdraw your money after 5 years you will then have a real return of $45. If your retirement date is many years in the future, you have plenty of time to recover any losses you’re experiencing now. And this is why you should not sell off your investments or be worried.
Now that you have an understanding of why these dips aren’t as scary as they seem, we will discuss how you can actually benefit from them.
In Q4 2019, the market was up and had experienced its longest expansion to date. Everyone was making money and loving it. Let’s say for this example that the S&P 500 Index was trading at $100/share in Q4 2019. Then along came the coronavirus, which led to global shutdowns, the fear of supply chain disruptions, job losses, and stocks plummeting. So now with the coronavirus in full effect, let’s say the S&P 500 Index is trading at $80/share at the end of Q1 2020. The stock lost 20% of its value, but basically what this means is that the stock is on sale. (This assumption only applies to well-diversified portfolios, or index or ETF style funds. It can, but does not always apply to individual company stocks.)
Let’s take a look at a tangible example. If you want a pair of Nikes that retail for $100, and then buy them for 20% off during a sale, you would say you got a good deal on them. The same goes for stocks. Next week the Nikes will be priced back at $100, and next year the index fund’s price might be back up to $100, and in both scenarios it is best to buy at the sale price.
While the sale prices of goods are more transparent and well defined than stock prices, the principles behind buying at the lowest possible price remain constant. Timing the perfect buy is very challenging, but next week, we will discuss the process for investing during a downturn.
[…] the dips in the market by buying stocks “on sale”. (If you haven’t read that, you can find it here.) In that post, I gave the example of a pair of Nikes going on sale for 20% off, and we concluded […]
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