If you are invested in the stock market, you might cringe when you see your portfolio drop 10%. Even show a little tear when it drops 40% but you should not go through all of this. I have already talked about why you should be glad to invest in a bear market. Today, I will expand a bit on the topic with a few tactics to ease the ride. There is no reason you should not thrive in downturns and accelerate your wealth accumulation.
Stock returns without crashes
Before diving into the topic, we should look into hypothetical history. Imagine if stock prices never dive and the market simply had a smooth ascent instead of plummeting every few years.
The economy would be better, the massive unemployment and bankruptcies would never happen but what about investors?
For long-term investors like me, the returns would have been far worse than with the sharp declines our markets actually incurs. If recessions never occurred, long-term investors would not have the possibility of reinvesting their dividends. Nor invest at discounted prices.
No one likes roller coasters… – Mr. Investor
The beauty of crashes is that it gives the advantage to long-term investors who reinvest their dividends. Looking back at history, reinvesting dividends in market lows almost doubled the total return of the S&P500 index (see figure below). Even in periods where dividend payouts were cut a whopping 50 percent, stock prices fell even more!
As a result, the total return for investors actually increased over the long-term. The extra shares you would have purchased during a bear market would have been greatly discounted. This would have caused your returns to grow astronomically once the market recovers.
It works because the market always recovers
For example, if you have Vanguard S&P 500 ETF (VOO), currently at $187.27 at the time of publishing, and you are earning a 2.13% dividend. A crash would allow you to buy some shares at lower prices with those dividend payouts.
Buying shares through dividend reinvestment at $170, $150, or even $100 would greatly increase your total return once VOO returns to the $187 mark and beyond.
As shown below, market crashes historically recovered quite rapidly. For a 50% drop, it is estimated to recover in only 2.3 years, which is really negligible for a long-term investor.
Data: NYTimes Source: FlannelGuyROI
Most investors who got whipped out in market crashes either were investing on margin or simply sold in a panic to cut their losses. If you stay away from the financial news and invest in index funds, you should be able to weather the storm and enjoy the sweet recovery.
Buying the discount
Another great way to drastically increase your total returns is to increase your position when the markets are low. As I stated before, it is impossible to time the market. Nevertheless, if you are investing a portion of every pay and constantly investing on a regular basis, market crashes will be beneficial for you.
On the other hand, if you are investing in a lump sum, you can benefit if you invest once a year or bi-yearly but I do not suggest you try to time your entry. Trying to spot the bottom of a crash is very risky and you might end up staying on the sidelines when the market recovers.
Timing the market is a loser’s game
If you try to time the market, you will miss it. I invest on a regular schedule, whether yearly, monthly or every paycheck, to cut out market timing of the equation. Some prefer to buy the dip by investing only after a decline in the market.
This is a valid strategy for indexing given the probability of recovery compared to stock investing where a dip could be the start of a drop towards bankruptcy. However, I don’t adhere to this strategy since it is trying to time the market. It won’t be an optimal investment solution over the long run. In addition, waiting for right time to get in is statistically worse. For any given year, you have 3.5 times more chances that the market ends up higher.
A study from Ned Davis Research found that from 1900 through 2013, there were only 32 bear markets where the index dropped more than 20% from its peak (one every 3.5 years). On top of that, if you are waiting to invest and waiting to spot the bottom, keep in mind that the average bear market takes only 15 months to recover according to Azzad Asset Management. This leaves little time to purchase at great prices and you will most likely miss the boat.
Waiting for the market to drop has a few uncertainties:
- When will you actually consider it a valid drop? 10%, 20%, 50%?
- Will the markets continue to grow while you wait for a dip?
- Do you really get a discount if the market was rising when you were waiting?
For example, let’s look at the chart above and assume you had a considerable amount to invest back in 2014 but decided to wait for a 10%+ drop before investing.
You would have waited until mid-October before finally investing at $172 per share of VOO, and that is if you time the drop perfectly and get the very bottom of it. Now, if you had invested in January, you would have paid only $167 for the index ETF. All of that without any luck or market timing.
What you could do, however, is increase your 401k contributions or non-registered investments when there is a dip. Here again, within a regular, planned, schedule. Investing without timing eliminates the need to constantly follow the market and focus on your investment. You will be able to relax and enjoy life.
Now even though I am talking about dividend reinvestment, I am not saying to target dividend-paying stocks in your portfolio. I believe in market efficiency and that indexing will generate the greatest returns over the long-run. I suggest you go with a balanced portfolio of ETF or use Personal Capital’s advisory service for a fully automated investing experience. When choosing dividend-paying stocks, you need to keep in mind that:
- Choosing one stock over a non-dividend paying stock is betting you know it will outperform.
- Stock picking could mean that some holdings go down to zero.
- There are some negative tax implications for dividend-paying stock portfolio since you cannot time when you will be receiving the dividend as you can do with capital gains.
Personally, I stick to a Total Market ETF (VTI) and reinvest the dividends automatically through a DRIP set up with my broker. DRIP stands for Dividend ReInvestment Plan and it is available through your broker to automatically purchases more share or fractional shares at the time of payout. This a great commission-free way to purchase new shares of great companies or ETF you believe in.
This is a great way to smooth out the market’s roller coaster and increase your total returns over the long-term. If you are interested, you can see my exact holdings and investments to learn a bit more about my strategy.
Live happily, Xyz.