Why buying a market drop can be good and bad

“Buy down” is an investment thesis often touted by securities traders and financial advisers for juice returns.

The idea is this: When a stock index like the S&P 500 is losing value, it’s a good time to buy, because stocks can be bought at a reduced price. Investors then reap the financial rewards when stocks rebound.

Monday’s market rout – and Tuesday’s rebound – is a prime example.

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The Dow Jones Industrial Average stock index fell 2.1% on Monday, its worst day since last October, amid investor fears over the delta variant of Covid. However, the market rebounded on Tuesday, jumping about 1.7% by 3 p.m. ET.

“The downside purchase has been a long success,” said certified financial planner Philip Chao, director and chief investment officer at Experiential Wealth in Cabin John, Maryland.

However, investors who are not careful can hurt themselves in the long run using this strategy, experts said.

The current environment is generally favorable for investing in equities, Chao said. Low interest rates and relatively low Treasury yields make stocks more attractive compared to other typical asset classes like cash and bonds, for example.

“There are many reasons why stocks continue to do well,” said Chao.

Many investors, especially those able to keep their jobs during the pandemic, may be able to afford to buy a little more now when the market goes down. Government stimulus funds have helped boost savings, already supported by spending cuts.

For example, personal income jumped 21% in March, the largest increase on record, in large part due to $ 1,400 stimulus checks issued to American households.

Americans’ 12.4% personal savings rate in May, although lower than any other month in the pandemic, was still higher than any point since the early 1980s.

“All this money is looking for a place to go,” said Dan Egan, vice president of behavioral finance and investing at Betterment. “When there is a big drop in the market, it’s a good use of that windfall.”

But investor psychology can cause an urge to sell – rather than buy – when the market falls. Unfortunately, this boost will likely cost them.

An investor who put $ 10,000 in the S&P 500 in early 2001 – and has remained invested ever since – would have turned it into $ 42,231 two decades later, for an annual return of 7.47%, according to JP Morgan Asset Management.

However, an investor who pulled out and missed the top 10 market days during that time would only have $ 19,347, an annual return of 3.35%, according to JP Morgan.

Seven of the best days on the market came in just two of the worst 10 weeks, meaning even a short-lived outing can turn out to be costly.

Investors who buy during a market rout should be aware that stocks can continue to fall before they rebound.

“Just because you waited for it to go down 10% doesn’t mean it can’t go down 20%,” Egan said.

However, there are caveats to the bearish buying strategy.

One big problem: Buying from the downside is unlikely to be a long-term financial gain for people who aren’t invested, but instead are sitting on a pile of money and waiting for a market sell-off to move their money. silver.

These investors can get a positive emotional return (knowing that they didn’t buy at the top of the market). But they also missed the rally to the upside, meaning they haven’t benefited from stock returns in the meantime.

“You can wait a long time for a substantial drop, during which the market rises,” Egan said.

Investors will be most successful with the strategy if they are already executing an investment plan and have a little extra money set aside for opportunistic investments, Chao said.

Investors can take a more regulated approach by executing the strategy piecemeal, he said. For example, if an investor has $ 10,000 in cash, the person can invest $ 2,000 at a time each time there is a 2% or 3% sale, instead of all at once.

The source of the funds is also important, Chao added. For example, it would probably be a bad idea to withdraw money from an emergency fund to buy stocks during a downturn.

Also, pursuing the strategy with a single share of the company – as opposed to an index made up of a basket of stocks – is a much riskier proposition, he said.