Stock market investors have watched broad market averages like the Dow Jones Industrial Average and S&P 500 plummet since early March. While both averages have started to trend upward again, the markets remain choppy. Many investors own stocks that are worth significantly less than they were in February.
Instead of focusing on diminished portfolios right now, though, the more prudent move is to understand why investing at low prices can be a good thing. It’s never a good idea to panic sell into falling markets, because you lose all your ability to recoup existing losses. But it’s equally important to understand that continuing to purchase stocks during a downturn is a really good idea. Why?
Markets Have Always Rebounded
Yes, stock markets can act like roller coasters. Historically, though, the U.S. stock market has always trended up after hitting down patches. That’s true of major plunges, like the one inaugurated by Black Tuesday in 1929 and resulting in the Great Depression, as well as the bear market of 2008, which went along with the Great Recession. The market averages lose significant percentages of their value and then, over time, regain those losses and continue to climb on top on that.
The end result?
The S&P 500 gained roughly 10 percent per year, once returns are averaged out over time, from 1926 to 2018. Stocks are an excellent long-term choice for growing your money – the key words here are long-term. If you’re funding retirement nest eggs or investment portfolios for the next several decades, stocks can power your returns over time.
Plus, with interest rates currently at historically low levels, asset classes like bonds and cash instruments offer investors very low yields. Stocks are one of the few asset classes that historically outpace inflation, which runs at 2 to 3 percent annually. Equity portfolios are a method of ensuring that your money doesn’t effectively lose money over time.
Low Prices Equal Bargain Shopping in Stocks
As a result of the relatively steady rise in stock markets over time, folks who buy in at low prices are the equivalent of bargain shoppers. Just as you might be disposed to pick up a good product at a discounted price, a plummeting stock might also be a good bargain. It’s when stocks are down that planning to purchase more, not less, is prudent and savvy.
Markets may move on fear and uncertainty in the short-term. Both those elements can send stocks spiraling down, and they’ve certainly played roles in stock market action during the Coronavirus pandemic. But eventually, fear dissipates and uncertainty vanishes.
We believe this will happen once again. Eventually, it’s likely that a Coronavirus vaccine will be found. Businesses will reopen. Uncertainty in the business climate will clear.
Once fear and uncertainty are no longer in play, stocks will return to values driven by fundamentals. One of the most widespread equity valuation metrics is the Price/Earnings (P/E) ratio, which divides the individual share price by earnings. Low prices can actually make P/E ratios much more attractive. If companies continue to earn robustly, the share prices eventually increase in line with earnings.
Fundamental value will ultimately help the share prices of companies that have done well in the pandemic. (And it’s wise to remember that, despite poor economic news overall, some company products are selling very well and have even benefited from the current environment.)
But fundamental value will also eventually help companies in sectors beaten down by the Coronavirus situation, such as airlines and restaurants. Do you think people will never fly in an airplane or eat out again? Eventually, those sectors will surely pick up. Their stocks may reflect the beaten-down nature of the businesses for a while, but eventually, they’ll start having up earnings years. And the stocks will follow.
Review your portfolio with your financial advisor to establish whether it makes sense to purchase more stock now, not less.
Dividend Reinvestment Buys More When Share Prices Drop
If you own stocks that offer dividends, and have dividends reinvested, your dividends purchase more stocks when prices drop. Let’s say you own 1,000 shares of a stock that traded for $100 in early 2020. The quarterly dividend is $0.50, or 2 percent annually, nicely above many cash instruments. A reinvestment at that point would have netted you $500, or five new shares of stock at $100.
If the stock falls to $80, however, and trades at that level during the next quarter’s dividend payout, you will receive 6.25 new shares at $80. You’ll have more shares due to reinvestment. Then, if the stock moves upward gradually, those new shares gain proportionally more than shares bought at $100.
Some dividend companies also allow shareholders to purchase additional stock with no trading fees.
Dollar Cost Averaging Over Time
Markets are choppy right now. What if there is no vaccine? What if governments have to close again? The broad market averages could fluctuate up and down.
Fortunately, there is a way to minimize the effect of down fluctuations on your stock portfolio – and maximize your bargain purchases! It’s called Dollar Cost Averaging (DCA).
DCA is simple. You don’t try to time when the up points will occur in the market, and you don’t try to predict down periods. You simply purchase consistently, within a given designated period (such as once a month), no matter what the market does.
DCA means choosing a sum to invest in stocks every designated period. Then, at the designated point, you purchase stocks worth that designated sum for your portfolio. Retirement plans such as 401(k)s already use DCA, since contributions are made every month.
In other words, if there’s a dip in the market in Month 2, you buy at a reduced price – realizing the bargain shopping discussed above. If the market rises in Month 3, you buy at a slightly higher price – but given the average 10 percent annual returns in stock markets, it’s likely that those stocks will eventually be worth much more. The market falls again in Month 4, and there you are again, buying stocks at a bargain price.
DCA also removes the likelihood that you’ll buy a lot at the top of the market, since you’re averaging stock prices every month.
If you have questions about what today’s environment has done to your portfolio or if you’re looking to work with a financial advisor in Utah, contact us.