You may not think there's a silver lining to a market correction. But for young investors, there's a counter intuitive potential upside and a simple investing technique that allows beginners to take full advantage of it.
I have no intention of casting a shadow on today's bull market, but with steady gains for the last eight years, we're deep into the second longest expansion in stock market history. And because our economy has historically fluctuated in cycles, there's likely a downturn somewhere in our future. (For more, see: Why the Bull Market May Last Until 2018.)
Experts citing high P/E ratios are indicating with more and more frequency that stocks are overvalued - making older investors, near or in retirement, incredibly nervous. But for young folks who are just getting started, this isn't all bad news. Instead, it could be the indicator of an approaching opportunity. Here's why:
- For those with a higher risk capacity a market correction acts more like a fire sale on stocks, where shares can temporarily be purchased at cheaper prices.
- As new investors, young people are not yet likely to have much capital at risk so temporary losses, if incurred, are relatively small.
- With decades left in the workforce, young people have the luxury to hold depressed shares until they've not only rebounded, but potentially grown significantly.
Making the Most of a Bad Situation
Every investor needs a plan and amidst the stress of a down market, a straightforward investment policy is essential. Without one, it's too easy to make emotional decisions based on the day's troubling news, inevitably leading to poorly-timed trades. Luckily, there's an easy strategy that will ensure you scoop up stock shares at the deepest discount without having to use a crystal ball. It's called dollar-cost averaging. (For more, see: Dollar-Cost Averaging Pays.)
Dollar-cost averaging is a technique to automatically purchase the same dollar amount of an investments at regular intervals (such as every month or with every paycheck), no matter what the market is doing. It allows new investors to grow the number of shares they own at a manageable pace and it is one of the easiest portfolio-building strategies to implement. The most skilled dollar-cost averagers follow these four simple steps:
- Determine an appropriate asset allocation.
- Decide on a monthly investment amount.
- Set up automatic deposits proportional to your asset classes.
- Forget about it.
Let's look at an example. Jane decides to invest $100 a month in a broadly diversified stock index fund. With her first deposit, she's able to buy 10 shares at $10 a share. In the following month the price climbs to $11.11, so she's able to buy only nine shares. In the third month the price dips to $9.17 and she picks up 12 more shares, and in the fourth month the price settles back at $10, for an additional 10 shares. After investing $400 over the course of four months, Jane now owns 41 shares of her index fund valued at $410. What just happened?
Because she was buying the same dollar amount every month - no matter what the price was - she was able to pick up additional shares at a discount when the value temporarily dipped. Did Jane have to do any market timing to achieve this? Did she have to look for a rise in the 20-day moving average? No, she just had to stick with it, not get spooked when values declined, and wait for the recovery.
A Buying Opportunity
When the market is trending downward, it can be stressful to watch each new deposit drop in value, and emotion can quickly get in the way of sticking to your plan. But if there’s no immediate need for those resources, and you’ve thoughtfully selected an asset allocation based on risk tolerance, then a market decline becomes a potential buying opportunity. And a set-it-and-forget-it system of dollar-cost averaging will ensure you're in the right place at the right time if the trend turns upward. With decades ahead for your investments to recover and compound, today's values don't matter as much as having a consistent habit of gradually adding shares to your portfolio. Even though some were bought in good times and others in bad, they'll all rise to the same height assuming the tides will eventually turn.
Back in 2007 I set-up my own dollar-cost averaging system to automatically fund my accounts twice a month. I paid little attention to it until after the market had hit its peak and stock values were in the downward free fall we all remember as the Great Recession. It was unsettling to watch my meager savings get cut in half in the blink of an eye. But since I'd already missed the boat on selling, it didn't seem like I'd have any more luck getting back into the market at the right time so I stuck with it.
As Wall Street burned, I dutifully made twice monthly automatic deposits into my index funds. While people older and wiser than me were selling out of their investments at the bottom - locking in huge losses - I continued to dollar-cost average my money into my investments, capturing more shares at lower and lower prices. This simple system gave me the dumb luck of buying shares within one week of the absolute rock bottom of the market. You can't time it any better than that.
Though older and wiser, I'm still doing the same thing. I'm not quite as young as I was in '07 and we find ourselves again gazing out from a dizzying peak. But my plans haven't changed. So with a slightly less aggressive asset allocation, I'll be continuing to dollar-cost average my way through whatever hills and valleys the economic cycle has in store for us. I'll cheer when markets do well and buy up stocks on sale when they don't. (For more from this author, see: Why I'm a Lazy, Passive-Aggressive, Cheap Investor.)
An earlier version of this article appeared on insightpersonalfinance.com.