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What’s the best — and safest — way to invest during a market downturn?
Maybe the best advice is to stick to your plan.
A solid financial plan allows you to invest the way you want, regardless of which way the market is heading. That’s especially true if your plan is to buy and hold for the long term.
Rather than chasing returns, the next meme stock, or cryptocurrency, having a good investing plan will help you weather any market downturn.
When Investing During a Market Downturn Is a Good Idea
Although you’ll likely encounter a market downturn during your journey toward financial freedom, in the long run, the market tends to go up. Analysis from the Personal Finance Club shows that, over the last 100 years, the stock market returned around an average of 10.8% consistently.
Novice investors with a solid financial plan understand investing for the long term. This means sticking to the plan through market crashes and upswings. Stick to your financial plan, keep learning, and lean into the ups and downs of the market.
What Are the Characteristics of a Market Downturn?
Panic. Yelling. Massive selloffs. Wall Street in the news. Stock-picking gurus and experts telling you to buy or sell certain stocks. I’m only half-joking.
One obvious characteristic of a market downturn is when blue-chip or large-cap stocks drop in price. These are the large corporations we all know: Facebook, Google, Microsoft, Amazon, Apple, Netflix, Coca-Cola, you get the point.
Another characteristic of a market downturn is when the “market is down.” A more concise way to say this is that exchanges are taking losses consistently. Every day you’ll hear the S&P 500, Nasdaq, or Dow Jones went down again.
If you’re invested in a fund that tracks the S&P 500 or the total stock market, you’ll notice your portfolio going down. You’ll know which index your fund follows, most likely, by its name. Otherwise, information about the index that the mutual fund follows can be found on the brokerage site or morningstar.com.
Why Does a Market Downturn Lower Stock Prices?
Stocks are not immune to supply and demand. If the market crash causes everyone to sell, not as many folks will be looking to buy. As selling increases and buying decreases, the prices of stocks begin to lower.
Perhaps businesses aren’t making record profits due to recession, inflation, or other issues, such as a pandemic. The value of the business begins to lower, and that causes prices to drop as well.
When Is the Best Time to Invest in a Market Downturn?
So many clichés, so little time. The best time to invest was yesterday; the second-best time is now. Time in the market beats timing the market.
Aside from these old chestnuts, there are three winning and losing strategies for volatile periods in the stock market:
- Staying the course
- Reinvesting dividends and capital gains
- Tax-managing your portfolio
- Selling in panic mode
- Stopping automatic contributions
- Predicting the future
Long-term investors recover or increase gains after market downturns. Reinvesting dividends and capital gains equals buying more shares at a lower price automatically. Saving on taxes in the long-term means keeping more of your gains.
Conversely, selling during the lows means buying again at the low and having to sell even higher to recoup losses. Again, adhering to the “buy low” adage, stopping automatic contributions means missing out on the stocks that are on sale. No one knows the future, but historical analysis shows that stock market gains increase over time.
How to Take Advantage of a Market Downturn
Dollar-cost averaging takes little effort to take advantage of market downturns. Just keep investing periodically. More shares mean more gains per share. Continue dollar-cost averaging or even increase your contributions to tax-deferred and taxable accounts. Consider alternate investments like dividend stocks.
Why Should You Increase Your Contributions to Your Investment Accounts During a Market Downturn?
Stocks are on sale, of course! In all seriousness, if a stock or mutual fund price is lower ,you’re buying low. Over time, that growth compounds and you win. More shares for the same price means more gains when the price per share increases.
Financial Coach Nicole Stanley invested an extra $15,000 while navigating market downturns. Nicole isn’t worried about cryptocurrency dips, inflation, or other negative effects that occur alongside a market downturn.
What Is the Dollar-Cost Averaging Method?
In simplest terms, dollar-cost averaging is investing periodically — every paycheck, every month, etc. Rather than trying to time the market, dollar-cost averaging buys during highs and lows.
The advantage to dollar-cost averaging is that when you buy high and low, the average of your cost basis is in the middle. Your cost basis is the price at which you bought the stock.
Here’s a simple example of how dollar-cost averaging would be advantageous.
Let’s say you bought two shares of stock: one at $30 and the other at $50 twice in the same month. Your average cost basis is $40. But what if you bought at different times when you thought the stock was going to go down and it didn’t?
Say you bought the same stock the next month at $50 and think it will go back down to $30 since it dropped last month. But it only drops to $40. Now you have two more shares at an average basis of $45.
Last month, you bought at an average of $2.50 less per share. Now imagine multiplying that by 10, 100, or 1,000. $25.00, $250.00, and $2,500 more for the same stock by trying to time the market.
What Are the Benefits of Investing in Stocks That Offer Dividends?
One winning strategy is reinvesting dividends. Dividends are payouts by a company for each share of stock owned. Reinvested dividends buy more shares automatically when stock prices are lower.
Investments to Avoid During a Market Downturn
Investments to avoid during a market downturn are probably the same ones to avoid at a record high or even altogether. Approach high-risk investments, like startups or luxury goods, with caution in any market.
If you choose to invest in high-risk investments, use a strategy. Avoid trading with emotion. Stick to your investment strategy.
What Types of Investments Become Riskier During a Market Downturn?
An individual stock might become riskier during a downturn. The company may experience normal peaks and valleys during a bull market. During a bear market, however, companies could go bankrupt.
Why Should You Avoid Investing in Startups During a Market Downturn?
Investing in startups can be risky in any market as well. Statistically, a business takes an average of five years to turn a profit. Many businesses fold before the five-year mark. Businesses that haven’t hit the five-year mark may be more susceptible to failure during a market downturn.
Why Should You Avoid Investing in Companies Involved With Luxury Goods During a Market Downturn?
Luxury goods may be the first thing consumers cut during inflation or recession. This makes the company’s stock susceptible to market volatility. Consider inflation-proof investments as an alternative. Inflation-proof investments include TIPS, individual stocks, or real estate.
Stocks that are dividend aristocrats have paid dividends for 25+ consecutive years. Dividend aristocrats include household names like:
- Procter & Gamble (PG)
- Hormel Foods
- Cardinal Health
- Johnson & Johnson
- PPG Industries
- Automatic Data Processing (ADP)
- International Business Machines (IBM)
- Atmos Energy
- Consolidated Edison
NOBL is the exchange-traded fund that contains all these dividend aristocrats in one fund.
What You Can Do to Protect Your Investments From a Market Downturn
Keep the three strategies in mind: Stay the course, reinvest dividends, and tax-manage your portfolio. Be certain in uncertain times and have a plan for when a downturn comes. Prepare yourself for what you know is coming.
Consider rebalancing. If inflation or a recession is occurring during the downturn, consider increasing cash investments. Increase contributions to your emergency fund or open a high-yield savings account and start an emergency fund.
What Are the Benefits of Maintaining Your Stock Portfolio Instead of Liquidating During a Market Downturn?
The analysis from the Personal Finance Club mentioned previously shows the market tends to trend upward even after downturns. The analysis also shows that maintaining your portfolio tends to recover and often increase gains after a downturn.
The benefit of maintaining a portfolio is protecting yourself from risk — specifically, the risk of selling low and buying back high. Studies show investors who forgot about their portfolios had better returns. Your financial plan could include dollar-cost averaging and forgetting about your portfolio during a downturn.
How Can You Reduce Your Overall Stock Exposure by Selling Positions That Have Done Poorly?
One way to reduce your exposure is to consider your rebalancing strategy. Rebalancing is selling off positions when your asset allocation isn’t aligned with your investment plan.
Employer-sponsored plans like your 401(k) often offer automatic rebalancing. Robo advisors often offer this service as well. You may have to manually rebalance your portfolio in other accounts like a taxable account or retirement accounts like your traditional IRA or Roth IRA.
If you’re closer to retirement, rebalancing makes more sense. If you’re not planning to retire during the current market downturn or for the next few years, consider leaving your investments as-is. If your investments offer automatic rebalancing, leave them automated.
What Are the Benefits of Cash Investments During a Market Downturn?
Investing in a money market account or high-yield savings account for an emergency is a benefit. Although you won’t receive the greatest rate of return, having an emergency fund during a downturn or recession can bring financial security. When inflation is occurring during a market downturn, having cash reserves can help smooth the ride.
The Bottom Line
Currently, in early June 2022, the stock market seems to be experiencing a market downturn. Some strategies to protect your portfolio include:
- Stick to your investment plan and stay the course
- Look at alternative investments to add to your portfolio like real estate or REITs, TIPS, dividend stocks, etc.
- Do not cancel automatic contributions if possible
- Optimize your portfolio for tax efficiency
- Rebalance if necessary or adjust rebalancing options
- Avoid panic selling
- Do not try to predict the future
Your financial plan is based on your preferred asset allocation and risk tolerance. Stick to your plan throughout all of your taxable and retirement accounts and you’ll ride a market downturn just fine.