Riding The Bear Into A Bull Market
Nobody likes to see the stock market take a tumble. We like it even less when that tumble becomes an extended slide. Losing money isn't part of any investor's plan, so we're often tempted to take our money out of a declining stock market and put it somewhere that we perceive to be safer. Of course, as soon as we make the move and pull out, we start wondering how and when to get back in so that we can avoid missing out on the potential gains if the market recovers. (Pulling your money out of the market may help you sleep at night, but is it a smart move? Read more in Stashing Your Cash: Mattress Or Market?)
Easing Back In
Dollar-cost averaging, an investment strategy based on investing the same amount of money at regular intervals over a period time, is one way to re-enter the markets. When this method is used, each investment purchases fewer shares when prices are higher and more shares when prices are lower. This results in a lower per-share price than if a constant number of shares was purchased at regular intervals. It also avoids the regret of making a lump-sum investment and then seeing stock prices fall.
While dollar-cost averaging also means that you won't be making a lump-sum investment at the bottom of the market and maximizing your profits when the market rises, investors tend to feel the pain of loss more than they enjoy the victory of a gain. It's the reason so many investors hold a losing position all the way to the bottom rather than sell out and minimize the loss. It's also the reason why investors are so fearful during bear markets, even though both up and down markets are a regular and expected part of the business cycle. (Learn more in Dollar-Cost Averaging Pays.)
Another take on dollar-cost averaging involves investing half of your assets in a lump sum and the other half over time in regular intervals. This method puts a larger amount of your portfolio to work more quickly. (Learn more in Finding Your Investment Comfort Zone.)
A Defensive Approach
While it is not possible to predict the exact moment when the market will turn, it is possible to make adjustments to your portfolio based on prevailing market conditions. Just as the stock market is subject to the cyclical movements of the business cycle, there are sectors of the economy that tend to move in flux with those cycles and sectors that are less affected by them.
Stocks that are less affected by business cycles are referred to as non-cyclical, or defensive stocks. Utilities and consumer staples are viewed as defensive sectors because investors need to fuel their cars, heat their homes and feed themselves, regardless of economic conditions. Just keep in mind that dinner might be macaroni and cheese instead of filet mignon. (These companies may not be flashy but they offer investors structure and diversification A Guide To Consumer Staples or check out Guard Your Portfolio With Defensive Stocks.)
Cyclical sectors, on the other hand, tend to move in tandem with the economy. Industrials and information technology are two solid examples of cyclical sectors. When the economy is on a downturn, consumers limit their purchases. In turn, factories produce less and charge less for their finished goods. These developments hurt the profitability of industrial companies, which leads to declining stock prices.
A similar situation occurs in the information technology sector. When times are tough, businesses don't have the money required to invest in technology upgrades. Consumers are also less likely to spend money on new computer equipment. As a result, sales decline and stock prices fall. (Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks in Cyclical Versus Non-Cyclical Stocks.)
Moving from the sector level to the individual company level, companies that rely on stock price appreciation to fuel their growth tend to have limited appeal to investors when stock prices are falling. On the other hand, companies that pay regular dividends and have a long history of increasing their dividend payouts can be particularly attractive when stock prices are flat or down.
Healthy dividend payouts tend to be associated with blue chip stocks. Blue chips are known for having long histories of profitability and solid management. If you can find a blue chip utility company or firm that produces basic consumer goods, take a look at the history of divided payouts: you may have found a defensive investment. (For a closer look at how a company can put its profits directly into your hands, check out The Importance Of Dividends, Dividends Still Look Good After All These Years and How Dividends Work For Investors.)
A Long-Term View
What's the best method of getting back into the market and the best place to put your money? It's simply not possible to know. Nobody knows when the market will hit bottom just as nobody knows which stock market bounce is actually the start of a rebound. What we do know is that, over 20-year periods of time, the overall trend in the stock market has historically been upward. Even the Great Depression lasted only a dozen years. Despite this knowledge, investors still panic and pull their money out of the market when the bears are on the prowl. (When everyone rushes to dump their stocks, you may find yourself with a great buying opportunity. Learn about it in Profiting From Panic Selling.)
Such knee-jerk reactions are often the result of little or no planning. Consider, for a moment, the idea of pulling money out of the market to avoid short-term losses. If you need your money to cover short-term needs, it probably doesn't belong in the stock market at all. Likewise, if you don't need your money for at least a few years, the odds are that you could ride out short-term volatility simply by waiting for the market cycle to play itself out.
To avoid getting caught up in the frenzy the next time the market takes a tumble, plan in advance. Meet with a professional financial advisor, allocate your assets in a well thought out manner, and let the market run its course while you sit back and watch. When you get the urge to move your money in and out of the market in an effort to avoid losses and make a profit, stop for a moment and think about the number of people that you know who got rich by market timing. Unless you come up with a long list, you're probably better off sticking with a plan, and giving the market time to settle.