A sharp stock market downturn — or wild swings like the ones we’ve been experiencing in recent months — often serve a signal to re-evaluate our investment strategies.
If anything, a sharp drop in your equity investments may automatically take your asset allocation off kilter, disproportionately increasing the section of your overall portfolio represented by other investments, such as bonds or cash, that may have not lost value.
A market downturn is also, contrary to many investors’ knee-jerk reactions, a good opportunity to take advantage of lower stock prices, especially if you’ve got a long investment horizon ahead of you.
Today, Mint explores some options for where to put your money in a bad market (with an eye toward inexpensive investments.)
Avoid Knee-Jerk Reactions
While a market downturn is typically a good wake-up call to reevaluate your investments, that doesn’t mean you have to make radical changes to your portfolio.
Investing guru and Vanguard founder John Bogle, for instance, maintains that asset allocation is the key ingredient to investment performance. (Bogle offers a brief introduction to asset allocation in a January 2009 Wall Street Journal interview.) If your portfolio is already constructed in alignment with the appropriate asset allocation for your age and risk tolerance, there is no need to panic and change that arrangement now.
Countless other experts (including I Will Teach You To Be Rich author Ramit Sethi) remind us that emotionally-charged reactions to bad markets tend to be mistaken. Rather, we are best served by defining a long-term investment strategy that is built to weather both up and down markets.
Consider Your Time Horizon
Another important factor to keep in mind is your time horizon. If you are younger than 30, a bad market is an ideal time to swoop in on underpriced “bargain” investments (more on that below.) Because you theoretically will not withdraw from your portfolio for many years, you can afford to tie up some money in stocks that seem sure to rebound later on.
That is less true of people with shorter time horizons, such as those who are just five or ten years away from retirement. If you’re in that group, you will be better off focus less on bargain hunting and more on diverting your investment capital to the “safe harbors” of bonds or high-yield savings.
When the market tanks, bargains abound for those who know how to take advantage. Unfortunately, many investors get so caught up in generalized fears about “the economy” that they neglect the lucrative investment opportunities waiting to be capitalized upon. As an antidote to such thinking, Warren Buffett told the New York Times in October 2008:
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
Following the fall 2008 crash, Harvard MBA John T. Reed noted that many large companies were valued by the stock market for less than the amount of cash in their own bank accounts. Charles Schwab, for example, was valued in October 2008 at just $21 billion based on its stock price, despite having $27.8 billion in cash in the bank.
These opportunities, Buffett, Reed and others contend, represent inexpensive and highly lucrative opportunities for ordinary investors to profit from the irrational despair that permeates bad markets. To spot them, keep an eye out for companies with strong fundamentals which other, more fearful investors seem to be irrationally staying away from.
Bonds are another relatively inexpensive option for intelligent bad market investing. One of the fundamental features of bonds is that they typically trend in the opposite direction of stocks. This is why a portfolio diversified across both equities and bonds (or fixed-income investments) will generally perform better during a stock market downturn than one that’s heavy on equities.
If equities are performing poorly, there is a high likelihood that bonds (whether corporate or treasury) can offer at least modestly higher returns. Municipal (local government) bonds also offer the perk of not having to pay tax on your interest earnings. As a trade-off, the returns on municipal bonds tend to be more modest than other, fully taxable investments. In a bad market, though, many are willing to accept lower returns in place of losses elsewhere.
High-Yield Savings Accounts
A smart bad market option for the ultra-conservative (or those with short time horizons) is a high-yield savings account. Be advised, though, that even the interest you could earn these days with a high-yield savings account is not nearly as high as the return on investment you could get over the long run from equities.
Still, these days you could find high-yield accounts with yields as high as 2% or 2.5%: much better than the paultry 0.5% yields offered by traditional savings accounts. The benefit, again, is that this option is at the very least extremely safe compared with buying stocks, since all bank deposits have FDIC insurance up to $250,000 per individual. That means that even if a bank went belly up, the government is guaranteeing that your money is intact.
Any changes in investment strategy pertaining to bad markets should take into account your own circumstances. Those with lengthy time horizons are perfect candidates to roll the dice on some of the inexpensive bargain stocks that feeble-minded investors tend to avoid. Those with shorter time horizons or more conservative approaches to investing are better suited to consider bonds or high-yield savings accounts.