Market drops cause many people to reduce contributions to 401k accounts and other retirement accounts. They may also hold off on sending money into taxable investments like mutual funds, holding money on the sidelines to “wait for a good entry point” or “wait for the markets to settle down.” The trouble is that market moves upward happen very quickly. Wait on the sidelines for the market to start recovering before you invest and you may miss a lot of the recovery. Even worse, you may buy just as it peaks and fails a second time. That’s buying high and selling low.
In fact, most of the return generated by the market happens very, very quickly. While the average annual return for stocks over long periods of time usually lies somewhere between 10 and 15%, the average return on most days is nothing. Or to say it differently, while the return on any given day might easily be +1% or more, there will be just as many days where the market is down 1% or more. This means that if you average the returns on most market days, adding the positive and negative days together, you’ll get an average return of around 0%. This is because the market is always priced nearly correctly for the current news and outlook for the economy. Moves in the market are then random fluctuations on top of this stable price pattern.
So how do you get returns of 10-15% over long periods of time if average change in the price of stocks is 0%? The answer is that you have a few remarkable days. You have a few days or weeks where the market climbs ten or twenty percent. The same goes for individual stocks. They tend to move up very quickly, then plateau and trade within a range for a weeks or months. The reason is that news comes out that causes a sudden price move. For the market, news comes out the Federal Reserve is cutting interest rates or that profits from holiday shopping are up. For individual stocks, the company releases a new product, or has earnings come in higher than expected, or announces that it will buy back shares of stock or increase the dividend. These things cause immediate moves in the price of the market or the individual stock. Be sitting on the sideline when this news comes out, and you’ll miss out on most of the return you would have gotten if you had been invested.
So the answer on whether you should increase how much you are contributing to investments when the market is down is no different from the answer to whether you should increase your contributions when the market is up. If you are not contributing enough to meet your goals, which might include a secure retirement, paying for college for your children, or becoming financially independent before you reach fifty, then you should increase your contributions. When you are doing calculations to aid you in making these decisions, you can estimate returns in the 10-15% range if you will be investing for ten years or more. If you’ve already got plenty socked away, or if you are getting close to the time when you’ll need the money, you should look at remaining stable with your contributions or even taking some money out of the markets. The decision has a lot more to do with your personal situation than it has to do with what the markets are doing.
That said, declining markets often offer opportunities to buy in at lower prices. Some of the most amazing stock market advances have happened right after a major decline. For example, there were many great companies whose shares were trading in the single digits after the 2008 crash that went on to triple or even quadruple in price over the next year.
Now does this mean that if you invest more today you won’t see the value of your accounts decline? No, not really. Just because the market has declined does not mean that it won’t go down further. Certainly it is lower in price than it was at the start of the year, which means that stocks are looking like more of a bargain than they once did, but there is no reason to think that they won’t get even cheaper. You rarely will catch the bottom of a decline, just as you’ll rarely sell at the peak. But if you keep investing regularly, you’ll be buying shares at lower prices by investing during declines. In the long run, that will result in bigger returns than you would get if you only invested when the market was rising.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.