Reverse Your Emotions. React Intelligently to the Market. It freaks out from time to time.

Benjamin Graham:  "Nobody ever knows what the market will do, but we can react intelligently to what it does do."

If the price is rising and everything you liked about the company still persists, such as strong earnings, high margins, low debt, and steady cash flow, then you might decide to invest more.  The market is finally recognizing what a great company you're invested in and people are beginning to buy.  As William O'Neil recommends, you should move more money into that winner.  Business owners buy more of what's working.

If the price is falling and everything you liked about the company still persists, you just stumbled onto a great company at a bargain price.  It's incidental that you happen to already own shares purchased at a higher price, you still have the chance to buy a great company on sale.

Think of owning property.  Say you bought a 10-acre parcel at $5,000 an acre because of its beautiful meadows and stream.  You build your dream home there.  Two years later, another 10-acre parcel adjacent to yours goes on sale for only $2,000 an acre.  It contains different parts of the same beautiful meadows and a different section of the same stream.  Would you react by selling the land and home you already own?  Of course not!  It's still beautiful.  Instead, you'd snap up the adjacent lot because of its identical beauty and the fact that it's selling at 60 percent less than what you paid for the first parcel.  That, in a sense, is exactly how you should react when a perfectly solid company drops in price without any fundamental reason for doing so.

React intelligently to the market.  It freaks out from time to time, but you don't need to.

• If the market goes haywire and drops the price of your company for no reason, smile coolly and buy more shares.  
• If the market goes haywire and drives the price of your stock through the clouds, buy more on the way up. (However, don't buy and consider selling bubbly priced stock).

Master investors say to buy more of what's working and to take advantage of price dips.  That seems to mean that no matter what's happening, you should buy more.  That's only true regarding price.  Price is not really the most important thing.  It seems to be and it's eventually the bottom line, but in the course of stock ownership there are a lot of things more important.  For instance, Warren Buffett keeps an eye on profit margins and return on equity.  If the company remains strong and keep doing everything right, the market will eventually catch on and the price will rise.

If you bought quality companies after conducting thorough research, you have little to fear in the markets.  You will prosper over time.  The market will rise and fall, gurus will claim to know where it's going and when, you will hold winners and losers, and by reacting intelligently to all this cacophony your profits will mount.

Should I Invest Immediately After a Small Dip in the Stock Market?

Should I Invest Immediately After a Small Dip in the Stock Market?

November 7, 2007 @ 3:00 pm -
Written by Trent
Categories: Investing, S&P 500, Stocks
Bookmarks: del.icio.us, reddit

This week, The Simple Dollar attempts to address challenging questions in personal finance by looking at both sides of the story and figuring out some of the factors you need to look at to make a decision.

Several times this year, the stock market has dipped more than 1% in a single day. If you read the advice of some writers, like in this article by Ben Stein, there is some strong encouragement out there that a dip in the stock market like that means it’s time to buy a broad-based index fund. On the other hand, if you follow the advice of other columns, like this one by Ben Stein, you’ll hear that market timing is bad.

Which is right and which is wrong? There’s not a really easy answer to this one, so let’s look at both sides.

Market’s Down? Buy!

If you look at the long term history of the stock market, stocks go up in value. There has never been a thirty year period where stocks are down, and over the entire twentieth century, the broad stock market increased in value 20,000%. Because of that, it’s reasonably safe to assume that stocks are a lucrative long-term investment.

Now, on any given day, if the stock market drops in value, you can effectively buy in at a cheaper price than the day before. Let’s say you could buy an index fund for $1,000 that included a bit of every stock on the New York Stock Exchange. Then, in one day, the market drops 4%. You can now buy that same share for $960 - it’s effectively a sale!

In other words, buying a low-cost index fund when the stock market drops is the equivalent of buying it on sale. Any time you can buy a solid long-term investment on sale - and it’s all legit - is a deal you shouldn’t pass up.

Ignore Timing and Stick With a Real Strategy

In a mathematically perfect world, the above scenario would be just fine. If the long term trend is up but the very short term trend is down, and you knew that for a fact, you really could clean up on the stock market. Unfortunately, it’s not all perfect like that.

For example, down days on the stock market have different meanings. A day where nothing much happens can be a slight down day, but devastating financial news can be a monster down day. There are all sorts of varieties of individual days on the stock market, and they may or may not be part of larger trends.

Since 1950, using the S&P 500 as an indicator, any random day has a 53.8% chance of being a positive day. There’s also a 54.1% chance that a down day will be followed by another down day and an up day will be followed by another up day. In other words, if you buy on a down day, the odds are better than half that the next day will also be a down day, which means you bought at an elevated price.

The market is effectively random on a day-to-day basis, so playing games like timing the market by buying when the market is down tend to offer not much reward (and often some loss) in exchange for the effort of playing the game. An intelligent investor will simply follow a “buy and hold” strategy or a dollar cost averaging strategy (by buying in at regular intervals, regardless of the market) and sitting back and ignoring the day-to-day changes in the stock market.

My Take

If time were not a factor, it might be a worthwhile endeavor to try the “buy when the market is down” approach over a long period of time. Due to the randomness of the day to day stock market, you wouldn’t gain a whole lot, but you might be able to eke out a small positive return, on the order of a fraction of a percent, over a long period of time (with possible bigger gains or a small loss over the shorter term).

However, the time investment to follow this strategy day in and day out would make it not worth one’s time, unless one did it on a fully automated basis.

To me, market timing makes the relatively volatile investment that is stocks even more volatile and thus not worth the time. I see no problem if you’re about to buy in and jump on board immediately after a down day, but to invest with such timing as a regular strategy probably won’t afford you much serious gain. There is perhaps a tiny gain to be made here, but not a significant one in terms of the time invested. (My comment: Agree totally. That's why I hardly ever queue when I sell or buy a stock.)

http://www.thesimpledollar.com/2007/11/07/should-i-invest-immediately-after-a-small-dip-in-the-stock-market/