Investing seems easy when the stock market is in an up swing. The idea is that you identify a stock or investment that is rising in value and put money into it with the hope that it will continue to do so. Since it already has the momentum to rise in value, it is more than likely that it will continue. I do this type of investing all the time. In fact, momentum investing can be simply defined as buying stocks that have high and positive returns while selling those that don’t. This seems easy enough but is it good to invest when the market is down?
Investing in a down market give you the opportunity to buy stocks at a lower price which can potentially be a bargain, take advantage of reducing your average cost per shares, and allow you to buy more shares of a stock for the same price.
Buying at a Bargain When the Market is Down
When you go to the retail store and see signs that say 20% off, chances are you get that little voice inside that says, “I smell a deal!” The stock market is no different. A lot of investors are waiting for these types of opportunities to present themselves. If you believe the market is down temporarily and that it will soon rebound, you may see this as the perfect opportunity to buy. If you are right, you bought the stock “on sale” and will benefit when it’s true value returns.
Take this example of the stock ticker FIVE.
Here is a screenshot showing the trend over the last month and a half:
It appears that this stock is suffering greatly doesn’t it! After all what could make a stock take such a drastic sharp turn? Sometimes it can be a bad earnings report, other times it can be market noise which can be news events that create stock prices to turn even though the company hasn’t changed anything fundamentally.
Here’s what FIVE looked like over the last 5 months:
For some, that same graph we saw earlier, could be interpreted as strong opportunity to buy. If you believe a stock is dropping value and it is not consistent with their performance, earnings, and what you perceive the value to be, it may be a great time to buy. It all depends on your particular outlook of the stock and your strategy.
Averaging Down During a Down Market
Another reason, many people buy during a down market is to capture more shares of a stock they already own in a process known as averaging down. Take this example.
You buy 100 shares of stock ABC for $50 per share ($5000). You believe the stock will rise to at least $75 over the next few years which would earn you $25 per share ($2500). Suddenly, there is some news that shows a new competitor has entered the market and people start selling their shares of ABC out of fear that they will not be able to compete.
You think this is crazy though because the last quarter showed their largest gain in subscribers and revenue. The stock price drops to $40 per share. You could either sell along with the crowd and lose $10 per share ($1000) or you could buy 100 more shares at $40 each ($4000). Now you’ve averaged down your cost per share to $45.
So, if the stock does reach $75 like you predict, you will now make $30 per share instead of $25 and earn an additional $500. Of course if the stock drops down to $35 per share, you will have magnified your losses. Averaging down is a good strategy for locking in lower entry points but it also magnifies your risk. Make sure you consider this if you decide to follow this path. Diversification is a very essential consideration when you are buying more of the same security.
It’s Important to Have a Plan!
If you decide to invest in a down market, the most important thing is to just have a plan. It’s easy to get emotional when stock prices seem to be tumbling. Although buying opportunities are there, determining when the right time to invest can be tricky. There are a few things that should keep in mind if you decide to invest in a down market. First, determine your risk tolerance and time horizon. Next, make sure you are investing for the right reason and not just experiencing shiny object syndrome. Lastly, identify when you plan to sell.
Time Horizon – Is This a Long Term or Short Term Investment?
As I mentioned, since investing in the market during a down turn is often a little riskier, it makes sense to ensure you have the right outlook as far as how long you plan to leave your investment without withdrawing it. If you are a short term stock trader, trading during a downturn is often riskier. It doesn’t mean that you can’t find stocks that are undervalued or at a bargain price. It just means to be cautious.
Long term investing gives the stock more time to settle back into a favorable trade that gives you good returns. If you can leave the money for a few years, you are more likely to see the stock recover. Also, people that are investing with more of a long term approach are usually more patient and less likely to make a trade in haste.
Don’t Lock in Losses to Get a Good Deal
I’ve already mentioned how difficult it is to time the market. Always remember, there will be no shortage of good trades in the future. This means that if you see a stock that is highly undervalued and you really want to invest in it, don’t sell stock that you have lost money in, just to capture gains in another stock. What this does, is guarantees one loss for the possibility of making money somewhere else.
The reason this is such a toxic approach is because you have now guaranteed losses and in order for your new investment to do well, it must first make back the money you lost in the first trade and then trade even higher to make the new trade worth it.
Let’s try with an example. You see a stock XYZ trading 20% lower than it was two weeks ago. You really want to buy it now because you think the stock is strong and will return to its previous price. The only problem is, all of your money is in other stocks. If you sell shares of stock that are currently down, you are locking in losses not to mention the trading fees.
The stock you sold may have come back up when the market returned but you have removed that chance now. Instead, you placed the money in XYZ. If the stock goes up, it must first overcome the money you lost in the previous stock before it begins making you a true profit. The alternative is that the price goes down and now you have locked in one loss to place in another losing trade.
When investing in a down market, it’s always best to introduce new money into the market rather than re-allocating invested funds.
When to Sell – Decide Your Exit Strategy
This applies to all investments really. If you see that the stock market is going against you and your account balance is dropping, its easy to get emotional and decide it may be best to call it quits and sell off your securities. Sometimes it makes sense to sell and sometimes it would be smarter to weather the storm and hold. How do you decide though?
Let’s start by taking a look inside one of my actual accounts. In the picture, you will see my portfolio go through a significant down turn. Although it was tempting to sell and closest family members said I should pull all of money out in late December, I didn’t.
The result? Not only did the market come back completely, but I ended up about 4% higher than when it started to go down. This saved me a massive amount of money. Why did I hold my stocks though and not sell?
Never Sell Because of Fear!
Fear is the enemy when it comes to the stock market. When you let emotion cloud your investing decisions, you not only miss out on opportunities but you can also make costly decisions that hurt your investments. One of the main reasons I didn’t sell at the bottom of the market was because I already told myself that I was a long term investor and that I would not try to time the market.
Even the best traders can not perfectly time the market. I knew that the market was going down. I also knew that I hadn’t lost any money yet because it was still in the market. If you take the money out of the market, you are locking in profits or losses. Until that time, your profits and losses are unrealized and can continue to change.
Could the market have kept dropping off? Sure, but I was confident that the overall market was not going to continue in that direction forever and I know that over the last several decades, you can average out the yearly rise and falls to equal about 8% growth each year. As long as I’m a long term investor, I do not worry about short term market noise.
Has the Company’s Fundamentals Changed?
Another way to see if the declining price of a stock is legitimate is to look at the fundamental principles. If the stock is losing value due to news headlines but you don’t see reason to believe that the profits, earnings or sales of the company are in any real danger, it may not be the best time to sell and there is a good chance the stock price will rebound once confidence is restored in the overall stock market.
I personally avoid selling based on news headlines alone.
Did you Reach the Price Target that You Set?
If the price of the stock exceeds the price that you wanted it to reach, there is absolutely nothing wrong with selling your shares. You were diciplined enough to come up with a price target and it was met. This is the ideal situation. I generally don’t set price targets because I buy stocks to hold them for a long term.
If a better opportunity comes along and I’ve already made a good return on the stock in question, I may sell. That’s been my strategy. I have some stocks that have earned me 40% returns since I’ve held them for 2 years and I have a couple that have made me more than 130% in less than a year. Your strategy may be different from mine.
So, Is Investing When the Market Is Down a Good Idea?
In short, it depends on your goals and dicipline. I gave you some reasons that I believe make a down market great for buying into the stock market. I also showed you some reasons to be cautious and when to consider selling or holding losing positions.
I have also written an article that discusses how to invest in a bear market which you may find helpful. A market that goes down 20% or more is considered a bear market. Not all down markets are bear markets and how you invest during a small down market may be different then a sustained bear market.
The truth is, a down market is dynamic. It can hurt the undisciplined investor and it can reward the investor with a plan. What is for certain though is that volatile markets will show big swings in prices. What you decide to do with those swings, is up to you.
I hope you found this helpful. What are your thoughts on buying stocks in a down market? Share them below! I’d love to hear and respond to them.
Until next time, let’s start investing!