What Happens to Index Fund Investments in a Bear Market?

When the market goes down, any investments tied to index funds will follow. Is this a reason to get out of an index fund when you suspect that a correction is around the corner? First of all, the reason you are in an index fund is because you know that the fund will do better than managers who try to time the market. So, unless you have a crystal ball that tells you precisely where to put your money instead of the index fund you are using, stay with it. But, if you had that crystal ball, you would not need the index fund!

Market Watch had a useful piece dealing with this issue. They say there is a test of whether you will win or lose in a bear market with index fund investing.
Their advice is to use a buy and hold strategy with index funds and not to bail out when the market corrects. Rather, use a dollar cost averaging approach and continue to add to your portfolio when shares are cheaper!

Is There Any Use for Active Investments Today?

If you have invested in dividend stocks and are using a dividend reinvestment plan, this is something that you cannot do with an index fund. While the cost of investing with index funds is lower than when you routinely buy and sell stocks or when you use a mutual fund, nothing beats the free reinvestment option offered by a dividend reinvestment plan! If your money is in a stock that has been paying dividends for more than 100 years, this is a difficult approach to beat.

And, it is important when investing to understand how a particular investment is going to keep making money over the years. When you invest in a fund that tracks the S&P 500 you are putting your trust in the American economy. But, if you have unique investment skills and knowhow, you may be able to choose some investments that will replicate the Microsoft story of growing nearly 1,000-fold over the years.

Best Investment Approaches Year in and Year Out

No matter if you choose investments where you will not lose any money but also not gain a lot, or if you go with the passive index fund approach, steady investing year in and year out is more likely to be successful for the vast majority of investors than trying to time the market.

The Problem with Investments in America

Both home ownership and ownership of stocks have declined since the Great Recession and have not recovered as expected. Financial Samurai looks at the percentages of Americans who own stocks or real estate.

Now that the economy is on fire, all Americans should be rejoicing in their wealth, right? Wrong! Only 52% of Americans own any stocks according to a 2019 Gallup poll and only about 63% of Americans own real estate according to the Census Bureau, down from a high of about 69% in 2004. Given these figures, the bull market has left a lot of people behind.

Back in 2007, 65 percent of adults owned stocks and today that number is 52 percent. Part of the reason is that many who got burned in the 2008 market crash have never re-entered the market. But, a greater factor is that small investors have been unable to take part in the steady appreciation of stocks over the last dozen years because they are just making ends meet. Our concern in this article is not the folks who have money and choose not to buy stocks (or real estate) but rather those who are living on a budget and are not investing.

While the stock market is an excellent place to grow wealth, the first place that Americans should and do invest is in their home. Unfortunately, home ownership took a hit with the Financial Collapse as well. More than 69 percent of Americans owned their home in 2007 and that number is below 64 percent today.

Investing in Your Home

Whenever we have written about starting to invest in the stock market, we have always mentioned home ownership as a greater priority. The Federal tax deduction for mortgage interest still makes home ownership a great investment. And, unlike trying to find money to invest in stocks, Americans are already paying for places to live. Getting out of the rental market and into home ownership is still one of the best investments on a budget.

Investing in Stocks

The point of investing in stocks is that over the years and decades the US stock market outperforms other investments. The key for most people to take advantage of this fact is to choose investments for the long term and not to try to time the market. Dividend stocks that have been paying dividends for decades or even more than a century are good choices. And using dividend reinvestment plans allows you to reinvest dividends without paying commissions and let your money grow even when you cannot purchase more shares. The key to making the best investments on a budget is to use dollar cost averaging to put a set amount into investments every year, quarter, month, or paycheck.

Dollar Cost Averaging

Dollar cost averaging is an investment approach in which a person invests the same dollar amount every pay period, month, quarter, or year. The first practical advantage of this approach is that a person can budget how much they will invest from every paycheck, bonus check, or whatever. The second practical advantage is that dollar cost averaging keeps you from investing too much when stocks are expensive and allows you to buy more when stocks are cheap.

Ideal Ways to Apply Dollar Cost Averaging

Smart investors take advantage of the tax benefits of an IRA or 401(k) plan from work. And, if your employer adds a little to your 401(k), so much the better. Simply select an amount to invest in either, or both, of these investment vehicles and stick with it year after year. When the stock market is overpriced you will not be tempted to pay too much and when the market is soft, you will get more stocks for your money.

Dollar cost averaging also works if you are using a mutual fund as an investment vehicle and especially if you are investing in an ETF that tracks the S&P 500 or another broad-based market index.
(Investopedia, Dollar Cost Averaging)

Benefits of Dollar Cost Averaging

As we noted at the beginning of this article, timing the market works for some folks. But, these folks have tons of available cash, the time and expertise to analyze intrinsic stock value on many potential investments, and the experience needed to “pull the trigger” at the right time to buy or sell most profitably. These folks are not the average investor who wants to put a little money aside with each paycheck and needs to know the best way to do this. For most folks, dollar cost averaging with a reliable set of investments is the way to go.

Motif discusses the real world of mom and pop investors and the benefits of dollar cost averaging.

A lot of people have a tendency to spend any leftover money in their bank accounts after all their bills are paid each month instead of investing for their retirement. In cases like these, using the disciplined trading approach of dollar cost averaging not only prevents them from procrastinating on their investing goals, it also helps them save for retirement and avoid wasteful spending.

Dollar cost averaging can also help investors who tend to be hesitant with investing and hoard cash out of fear or uncertainty. Having some cash on hand can provide peace of mind during volatile markets, but holding too much cash for too long can weigh down your portfolio’s return over time due to inflation. Plus, dollar cost averaging can help investors put their money into the market as quickly as possible on a consistent basis.

In writing about investing, we commonly deal with issues like fundamental analysis, best stocks to invest in, and where the market is likely going next. But, the folks at Motif hit the nail on the head in their discussion of the benefits of dollar cost averaging as it applies to the average investor who needs to develop a disciplined and reliable approach to putting money away and letting it grow for their retirement. Dollar cost averaging helps investors make their investments in a routine fashion and alleviates the risk of making bad decisions when trying to time the market or pick individual investments.

Dollar cost averaging in a bull market keeps an investor from buying too much when prices are too high and dollar cost averaging in a bear market lets an investor purchase at bargain prices when the market is bottoming out. When considering dollar cost averaging versus timing the market, most folks do just fine with an ETF tracking the S&P 500 and dollar cost averaging.

Mistakes to Avoid in Dollar Cost Averaging

US News and World Report has some good advice about following the rules mistakes to avoid in dollar cost averaging. Here are the high points of their slideshow.

Not Starting Dollar Cost Averaging Investing Early Enough

This is a practical and profitable approach to investing and to get the most out of it you need to get in early and take advantage of the compounding effect of steadily growing investments.

Not Being Consistent with Dollar Cost Averaging

This approach works when you apply it routinely. When you start second-guessing the system you are trying to time the market. Consistency pays off with dollar cost averaging.

Keep Your Investment Portfolio Balanced

If you have your money in an ETF that tracks a broad market index or in a mutual fund with the same properties, this is not an issue. But, if you have a nice selection of dividend stocks and AAA bonds, one may outpace the other. At some point, you may want to rebalance your portfolio or simply start using the ETF approach.

Letting Fear or Greed Control Your Investing

U.S. News notes that investors tend to abandon the dollar cost averaging approach at the worst possible times, such as when a bull market is about to collapse and they lose money. Or they sell everything just as a bear market is about to rebound. The point of dollar cost averaging is to pick a broad-based set of investments and stick with the investment program through thick and thin. Let the dollar cost averaging approach work its magic in both up and down markets over the years.

Not Keeping Track of the Costs of Investing

Dollar cost averaging works for a wide range of investment choices. But, if you are paying an old fashioned stock broker huge commissions for small investments every two weeks, you need to rethink your approach. Likewise, if your mutual fund’s fees are eating up your gains, perhaps an ETF that does not charge management fees will be a better choice. But, no matter which you use, dollar cost averaging, correctly applied is a good long term investment approach.

What Makes Dollar Cost Averaging Work for the Average Investor?

The first thing for an investor to do is to get started early in life. The beauty of dollar cost averaging with an ETF that tracks the S&P 500 or one of its sectors is that the investor does not need to have done a lot of research in picking good investments. The next benefit is that the investor develops a discipline early in life that becomes an investing habit. Then, the compounding effect of good investments takes over to create wealth over the years. Follow this link for more insights about the pros and cons of dollar cost averaging.

Buffett describes the analysis that led him to that kind of conclusion:

“The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Buffett said. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent, he said.”

There are single stocks like Microsoft in its growth phase that grow a hundred fold over a decade and there are years like the bull market from 1982 to 1999 when stocks gain closer to 15% a year. But predicting which stocks to buy and timing the market is not easy. If you want to aim for that 7% figure invest in a wide range of stocks or an exchange traded index fund that follows the S&P 500. Then the averages will apply to you. If you buy just a couple of stocks pick large cap stocks that have a long history of paying dividends and steady growth. If you want to beat the averages what do you do?

Big Picture Market Timing

There is a famous old saying credited to Baron Rothschild. The time to buy is when there’s blood in the streets. He made a fortune buying in the London stock market panic following the Battle of Waterloo in the 19 century. Market timing can be tricky but when big picture events drive all stocks down as in a stock market crash there are great stocks to buy everywhere. These are the US stock market crashes in the last 30 years.

• Black Monday, October 19, 1987
• Friday the 13th mini-crash, October 13, 1989
• Early 1990s recession, July 1990
• Dot com bubble, March 10, 2000
• Stock market downturn of 2002, October 9, 2002
• United States Bear Market of 2007-09, October 11, 2007
• Financial Crisis of 2007-08, September 16, 2008
• 2010 Flash Crash, May 6, 2010
• August 2011 stock markets fall, August 1, 2011

When a bull market comes to its later days there are typically late investors who will buy any stock based on the assumption that stocks always go up. When the market collapses these folks hold out until prices fall substantially and then sell in a fit of depression swearing off stocks forever. When to start investing in stocks, or at least when to pick up some good deals, is when there is the kind of blood in the streets scenario that a market collapse provides.

Dollar Cost Averaging

Buyandhold.com suggests that you set your goals and invest on autopilot.

Investing on a monthly basis instills discipline to an investment program. This is crucial since you need to invest during good times and bad. In fact, you cannot build a seven-figure investment portfolio without buying during crummy market periods. That’s when stocks are on sale. That’s when you get the best buys. That’s when your investment dollars offer the most leverage. If you fail to routinize your investment program by investing every month, you may not have the courage to invest during down markets.

Don’t wait to time the market and don’t wait until you have more money. Set aside a fixed amount that you will invest every month. This also lets you apply what is called dollar cost averaging. Because you are investing a fixed amount each month you will get more stocks for your money in down markets and not pay too much for stocks in a high market. When to starting investing in stocks in early and when to stop is never.

When to Start Investing in Stocks PPT