One of my close friends left their job this past year. When he did, we had a conversation about what he was planning to do with his retirement money inside his old employer’s 401(k) plan.
My friend was wondering how the money should be invested; if it should be rolled over into an IRA, or if it should be put into another 401(k) plan.
One of the driving concerns was the potential for the market to go down, causing him to lose money.
THE FEAR OF A MARKET DECLINE
There is a very prevalent fear of the stock market going down. Everyone, young and old, seems to have it set in their mind that if the market goes down, then we are all doomed.
If you turn on any financial media channel, you will certainly hear the reporters sounding the alarm bells at the slightest notion of a market drop.
On many occasions, I’ve had people ask me how they can avoid losing money in the market – if there is some way to avoid the downturns in the market and only get the upside.
No one has figured this out, yet. If they had, they’d be the richest person in the world.
But this got me thinking back to a Berkshire Hathaway shareholder letter written by Warren Buffet.
THE ORACLE OF OMAHA AT HIS BEST
If you aren’t familiar with Warren Buffet, he is the greatest investor of all time and is the current CEO and Chairman of Berkshire Hathaway. Through investing he has amassed a fortune worth tens of billions of dollars.
He lives and works in Omaha, Nebraska. Because of his successful track record, and the fact that the investment community closely follows what he says and does, he has been dubbed the “Oracle of Omaha.”
In the shareholder letter I was thinking about, Warren gives a quiz to the reader. The quiz goes like this…
“If you plan to eat hamburgers throughout your life, and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you’re going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?
These questions, of course, answer themselves. But now for the final exam. If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.
In effect, they rejoice because prices have risen for the hamburgers they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
In other words, if you are on the younger side and plan to be saving and investing for years to come, you should WANT the stock market to go down. And if you are older, and currently in or near retirement, then you should want the stock market to go up.
This is an incredible way to view saving for your goals and to reframe your thoughts on investing, especially for the younger savers. Imagine if instead of getting upset that the market is going down, you actually were getting excited to be able to buy more investments at a discounted and more favorable price?!
Of course, as the market is going down, your current investments will be declining, but it’s giving you the opportunity to invest more money at a lower price. Remember, you now get to buy more hamburgers at a discount. 😉
HOW TO MAKE BETTER INVESTMENT DECISIONS
So how can you increase your chances of making the right decision at the right time? How can you ensure that when the market goes down, you continue to buy more investments at a discounted price?
There is a great investing strategy called Dollar-cost averaging. If properly executed, it will help you on your investing journey.
So, what is Dollar-cost averaging?
DOLLAR-COST AVERAGE EXPLAINED
Dollar-cost averaging is a technique in investing where you buy a fixed dollar amount of an investment at regular intervals. As the price of the investment goes down, your fixed dollar amount will be able to buy more of the investment (i.e., more hamburgers). And as the investment increases in value, you will purchase less of it.
Let’s say you decide to invest $1,000 each month into your investment account, and you are going to buy shares of “Investment A.”
If you aren’t familiar with investing lingo, a “share” is just a piece of stock. We’ll leave it at that for now.
In the first month, Investment A costs $100 per share of stock. So, your $1,000 investment buys you 10 shares of Investment A. ($1,000/$100 per share = 10 Shares)
The second month, the price of Investment A has declined to $50 per share. So, your $1,000 will now buy you 20 shares of investment A. ($1,000/$50 per share = 20 Shares)
On the third month, the price of investment A has gone up to $200 per share. So now your $1,000 will buy you only 5 shares of investment A. ($1,000/$200 per share = 5 Shares)
YOU ARE NOT TO BE TRUSTED WITH YOUR INVESTMENTS
In recent years, we have learned much about the psychological side of investing. Unfortunately, what we’ve learned isn’t good, but it can help us plan for better outcomes!
Research has shown that humans are naturally poor investors. We are irrational beings that make poor choices at the wrong times.
For example, when the stock market is doing really well, going up and up, we get excited and want to buy more to get in on the fun. And when the stock market is doing poorly, dropping fast, we get scared and want to sell out of our investments to avoid further loss.
In essence, we do the exact opposite of the fundamental premise of investing, “Buy low, sell high.” We continue to buy high and sell low, and it hurts us in the long run.
This is exactly why dollar-cost averaging can be such a benefit to most investors; it creates a structure for investing that can help decrease the potential for you to make poor decisions when emotions are high.
It helps force you to buy more investments at a discounted price, even when it seems like things are bad because the price is declining.
THE PAIN OF LOSS
On top of our irrational behavior, we REALLY hate to lose money. In fact, studies show that it is twice as painful to lose money as it is pleasurable to earn money.
It’s no wonder why people like my friend are concerned about loss in their investment accounts. It seems people are constantly worried about this, and it only gets worse when they’re witnessing their accounts decline during a downturn in the stock market.
Heck, it’s scary to think about losing something you’ve worked hard to build up!
This is why having a predetermined process like dollar-cost averaging in place can help force you to buy more “hamburgers” when the price is declining, even though you’re getting more and more fearful.
So, how can you set up your own dollar-cost averaging game plan?
#1 – Decide how much you want to invest at certain intervals.
Depending on if you’re using money from each paycheck or if you have an existing nest egg, choose an amount you feel comfortable investing at each interval.
#2 – Choose your investing interval.
Next is the decision on how frequently you should be buying up more of your investments. There is no hard and fast rule on the interval, but I’d go with at least every 2 weeks (to align with the typical paycheck), and would probably opt for using a monthly cycle.
#3 – Choose the investments you are going to purchase at each interval
This is a whole different conversation to get into. My basic advice is to use low-cost ETFs or index funds that are well diversified.
#4 – Mentally prepare yourself for the downturns.
Tell yourself ahead of time that you will eventually see the account go down in value. It might be a momentary drop in the market, or it might be a full-blown economic recession.
Either way, it is important for you to recognize what is happening and STICK TO YOUR PLAN!
Regardless of what part of your investing career you are currently in, it always helps to have a plan.
By setting up specific strategies for how you are going to react during different events, you will help increase your likelihood of success.
Now that you know what to do when the price of “hamburgers” go down, will you actually do it?