Is all the talk
about recession getting you down? Does the drop in your portfolio make you want
to take your money and run for the hills? It turns out the worst thing you can do is panic. True,
no one really knows if we’re in a recession, and if we are, if it’s going to get
worse or when it’s going to end. But, your portfolio will do better if you stick
to your plan through good times and bad.
Recessions and the stock
market
When recession
comes knocking, the stock market declines about 26 percent on average, although
the 2000 recession generated an almost 50 percent drop. Recession-induced bear
markets last on average about 16 months. Recently, the S&P 500 has dropped
by more than 18 percent from its most recent high of 1562 in October 2007 to
1273 in March 2008. Only time will tell if this is it or there’s more to
come.
Wouldn’t it be
great if you could spot a recession before it happened and put your money
somewhere safe until the dust settles? In theory, timing the market is the way
to go--selling at the peak of the business cycle and buying when it hits bottom.
Alas, even the National Bureau of Economic Research’s (NBER) Business Cycle
Dating Committee has trouble identifying when recessions start and end. The
recession that began in March 2001 wasn’t official until eight months later in
November 2001. Then, it took almost two years after the fact for the committee
to announce the recession’s end. Meanwhile, the stock market has often bottomed
out before a recession is official.
Dollar-cost
averaging
A simpler and more
successful approach is to invest regularly through thick and thin. Dollar-cost
averaging is nothing more than investing the same amount of money on a regular
schedule. This simple strategy has a lot of advantages:
--Dollar-cost averaging takes the fear and
loathing out of investing. You simply invest the same amount of money no
matter where the market is.
--With dollar-cost averaging, you
automatically buy fewer shares when prices are high and more shares when prices
are low. You end up with a lower average purchase price, which means a
higher return. Stocks have increased on average 10 percent a year for more than
70 years. When you buy more shares at lower prices, you can boost that
return.
Even more
persuasive, consider the effect of the forty best trading days from 1986 to
1995. The total return for the S & P 500 during that time was 14.8 percent.
Without those 40 days (that’s about 1.5 percent of the trading days), the return
is only 2.5 percent.
--You develop a habit of investing the same
amount of money. Once you’re in the habit, it’s easy to keep going. If you
stop, it’s a bear to get back on board. Moreover, if you stockpile cash until
the stock market is on sale, you might be tempted to spend that money on
something else--your IRS tax bill, new shoes for your kids, or a down payment on
that mid-life crisis red Corvette.
Investing $1 a day
doesn’t sound too painful. That small daily contribution over 45 years amounts
to a mere $16,425 out of your pocket. Yet, the historical return of 10 percent
in stocks over that time would produce a nest egg worth more than
$300,000!
Reinvesting
dividends is another way to dollar-cost average. Every time you reinvest stock
dividends, you automatically buy more shares when the stock price is low and
fewer shares when the stock price is high. In addition, reinvested dividends are
painless additional contributions to your investments.
Diversification
Don’t forget to
stick to your diversification and asset allocation guidelines. Sure, investing
everything in the biggest winner would make you fabulously wealthy. But, no one
can pick the big winner. Some of your investments will do better than others and
some will even be losers.
You can reduce
your risk by diversifying your portfolio. Spreading your investments dollars
among different types of investments (stocks, bonds, real estate, and so on),
different industries, and different individual stocks helps prevent or at least
reduce stomach-lurching drops in portfolio value.
Every so often, you reallocate your portfolio. You sell
some of your holdings in big winners that have overgrown their percentage of
your diversification plan (locking in the gains you’ve earned.) Then, you take
that money and invest it in the portions of your portfolio that have lagged
(buying at lower prices). Of course, if you are reallocating money between
individual stocks, you want to make sure that the laggards are still good
investments before you sink any more money into them.
The good
news
Once the dark
hours of a recession pass, the stock market does indeed recover and go on to
greater heights. Your discipline during the recession will be rewarded when you
finally start to see you portfolio value on the
rise.
