Bear markets present a challenge for any investor with the end never in sight. How do we invest wisely in a bear market?
Stocks are often hailed as the winning financial asset to invest in for the long term. While stocks offer great potential in return they also hold an equal level of risk. Bear markets serve as a good reminder of the risk-return tradeoff.
During the first half of 2008 stock markets worldwide have taken a relatively severe proverbial beating with major indices dropping %15-%25.
Still, a bear market is by no means a cause to give up on stock investments. It’s just another natural phase in the life-cycle of stock investments which are invested for the long-term.
Amongst my favorite investment methods is an investment technique which enables us to:
- Gradually increase our exposure to the stock market.
- Invest in a timely fashion which usually suits our monthly savings.
- Enjoy stock returns while relatively limiting the risk we take.
- Invest in bear markets as well without dwelling on timing the market.
Dollar cost averaging is a well known investment method which perfectly suits bear markets. Most of us are dollar cost averagers investing timely in retirement plans and other long-term savings.
Dollar cost averaging is basically buying a financial asset or a certain portfolio of financial assets in a fixed timely manner regardless of share price. When prices are low dollar cost averaging results in buying more shares of a certain financial asset or portfolio and while prices are high fewer shares are purchased. With Dollar cost averaging the average “initial” cost of the portfolio is updating either upwards or downwards with each purchase thus diversifying risk over time.
Naturally there’s a price to dollar cost averaging. Since the investment risk is reduced so is the potential return. Had we invested a lump sum instead the portfolio risk would be higher but so would be the potential return.
There is a lot of criticism directed at dollar cost averaging. Academic research has disproven this investment technique as preferable to lump sum investing. I believe that for a household investor, much like me, who manages to save some money here and there dollar cost averaging helps ease fears of sharp portfolio drops by easing into the stock market when times are rough.
Poor Long Term Performance Poses a Risk Even To Long Term Investors
The most common hypothesis is that the stock markets will eventually return to growth patterns and will break previous price records. This has yet to be the case with the Nikkei 225 and the S&P500 since the 1990’s and 2000’s respectively. Dollar cost averaging has helped small investor take part in the stock market while not risking their sole savings, other than retirement.
If we examine the two stock market indices I mentioned we’ll see that since January 2000 the S&P500 has generated a negative return of 11.2% (-11.2%) without inflation! The Nikkei225 performed much worse over the past two decades with a negative return of 66% (-66%!!), again without inflation, since January 1990.
The S&P500 since 1999:
The Nikkei225 since 1989:
Dollar Cost Averaging Help Reduce The Risk
Let’s examine what would have happened had we started dollar cost averaging in the worst of times for these two indices. Let’s assume a monthly investment of 1,000$ up to today. Out two portfolios would look something like this:
Even with the current crisis and with the S&P500 and Nikkei 225 losing approximately 15% since January 2008 the two portfolios significantly outweigh any lump-sum counterpart. The S&P500 portfolio actually manages to yield a positive return. Remember, we started dollar cost averaging in the worst possible time to begin investing (right before a big crash).
My goal in this post was to suggest what I believe to be a sound, less risky technique to start investing in the stock market, even if it is bearish. I’ve recently started buying a monthly share of the MSCI world index using dollar cost averaging. Naturally, I encourage each and everyone to regard everything with the appropriate reserve and carefully examine whether a stock investment is right for you. As always, consulting with a professional is recommended.asset, Bear, investment method, investment methods, investor, natural phase, portfolio, portfolio risk, return, stock investments