Investing in Volatile Markets

The latest from Randy:

As we watch the stock market zip up and down it’s really hard to bring yourself to invest. When is the right time to invest? Should I invest all at once or a little bit at a time? Will the market go lower? Should I sell what I have in the market now?

The answer is if you are investing for your retirement you are a long term investor and the day to day gyrations of the market really don’t matter very much. Over the long term, timing is not everything. If you invested $100,000 ten years ago in a stock index fund you’d have gotten a market average return of about 8% and you’d have over $215,000 today. Investing in a “safe” money market account over the same period would leave you with only about $140,000. In that context, did the bear market of 2001 and 2002 really hurt you?

I know what you’re thinking, if you invested over that ten years but sold your investments in 2001 and 2002, you’d have done much better. The problem is that timing the market ups and downs is much harder than you think and trying to pick your spot to get in or out of the stock market is seldom a winning game. If you traveled back in time with a pile of cash and suddenly found yourself in the year 1929, right before the stock market crash, you’d happily hold nothing but cash. Further, given the depth of the depression that followed and the eventual slide into World War II over the course of the 30’s, it is a fair bet you’d want to hold that cash position for at least that decade. That would be a mistake as the S&P 500 rose 54% in 1933, 48% in 1935, 34% in1936 and 31% in 1938. Remember Peal Harbor? Seems like a good time to exit the market right? Wrong, the following year the stock market was up 16%. Over time, market timing is far more about luck than anyone’s ability to call the direction of the market. Good long term investing is not about luck.

What about the fear of investing in bad markets? Market corrections are normal, help us prevent a “bubble” market mentality, and frequently set the stage for stronger markets. Remember 1999? If a company had .com in its title it was thought to be a good investment. Measures that traditionally suggested strong companies like good earnings, broad customer bases and well developed products, were considered “old school” until the market imploded and the error of that thinking was exposed. Not until the bubble burst did investors again start to properly evaluate companies. As painful as it was, the bear market of 2001 and 2002 brought the investing world back to its senses and set the base for new highs in the market just a few years later. Don’t hesitate to invest when the stock market is weak. Market corrections give you an opportunity to invest more and at more favorable prices. Although it is sometimes the hardest thing to do, buying when the market is down is fundamental to the basic “buy low, sell high” principal. Rather than looking at market downturns as problems for your existing investments, consider it also an opportunity to better position your future investments. On the flip side, when the market is up, you need to resist the temptation to increase your risk profile and pile on when most everything is more expensive.

What if you are a happy investor in good markets and a scaredy cat (my technical term) in bad markets? That means you’re human. Turbulent markets can be really useful because we all need the occasional reminder that being greedy and taking really high risks does not guarantee really high returns. However, we also need to remember that being too careful and taking no risk usually means getting almost no real return either. There is a middle ground that is a much better path. Forget what the market is doing today and spend some time to establish your middle path of risk tolerance and once established, don’t vary it with the market ups and downs. If your high risk position is too uncomfortable when the market is down then you shouldn’t be taking such high risks when it is up either. Accept that you’ll need to take some risks to get good long term returns and stick with the path you set, in up and down markets.

The best thing you can do to become a good long term investor is to set a comfortable risk tolerance and investment plan and stay with it through the normal ups and downs of the market. If you are investing for the long term, don’t sweat the market timing, just keep investing in a manner consistent with the risk tolerance path you have set. In the long run it will be hard for you not to do well. Remember, it’s where you end up that counts, not how you got there.

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4 Comments

  1. Posted September 15, 2007 at 3:48 pm | Permalink

    I think we’ve been very fortunate that the market has done remarkably well for the last 30 years. Even the meltdown in the early 2000s still left the market much higher then they were in the mid 90s. Most young investors can ride out the volatility, but for those who are nearing retirement, a 5 year bear market, and 10 years of stagnancy can be devastating. While a little on the grim side, I believe that we can’t expect the 80s and 90s to repeat themselves. The tricker question is what do you do when you’re in that situation?

  2. Matt
    Posted September 15, 2007 at 4:20 pm | Permalink

    Dong, I think the basic answer is save more. This is also one of the hardest things to do (though not as hard as increasing your income). Everyone tries to optimize for investing, as they should, but if you’re salting your money away, even in relatively conservative investments, you’re in a much better position than if you’re not saving much and feel forced to invest aggressively in the market with the hope that it will generate the gains you need as you close in on retirement. I think it’s Prudential that’s come up with “the retirement red zone” and while it’s a lot of marketing, it does point out that the periods preceding and following retirement are crucial to your financial security later on in life.
    You can always try and go back to work, but the demand for your skills may not be what it once was.

  3. Posted September 27, 2007 at 1:37 pm | Permalink

    One thing, aren’t wars in foreign lands and the ensuing government spending generally good for the stock market? I mean look at our stock market since the Iraq War.

  4. Matt
    Posted October 1, 2007 at 5:18 pm | Permalink

    Jon, this is a good point about supply/demand. Usually during times of conflict where there is increased demand for goods, profits rise. Additionally, the government starts spending a lot more and that money is going somewhere (defense and construction in the case of Iraq). It doesn’t always have to be that wars drive economic growth (look at the 90s), but they do appear to be related.

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