By Jim Jubak
Start investing now? You’ve got to be kidding, right?
Not at all. This is a great time to be starting out as an investor. Or to be adding to a portfolio.
YES, even when the Dow Jones Industrial Average ($INDU) can drop 778 points in a day. And when government bank takeovers have wiped out the owners of both stocks and bonds. And when financial mainstays like Lehman Bros. (LEHMQ, news, msgs), Wachovia (WB, news, msgs) and Bear Stearns have all but disappeared overnight.
And even when stuffing your money in a mattress seems like it’s the best alternative.
Because it’s not. Money in a mattress or buried in the backyard becomes worth less every day, as inflation eats away at its value. Money in a savings account or a certificate of deposit barely earns enough interest these days to keep up with inflation. If your savings are barely keeping up with inflation, you’re going to have a tough time getting together the money you need for a down payment on a home, your kid’s college tuition or your own retirement.
To earn the returns you’ll need to get where you want to go, you’ll pretty much have to invest your money. For example, from 1926 to 2007, stocks returned an average of 10.4% a year. That was more than enough to beat inflation, which averaged 3% a year.
Buying, on sale or not, and holding
As scary as the financial markets are right now, this is actually a very good time to put your toe into the water. Remember, with stocks, bonds, real estate or just about any other kind of investment, you want to buy low and sell high. A famous and successful investor like Warren Buffett has put it this way: Buy fear and sell greed. In earlier centuries they phrased it a bit more bluntly: Buy when the blood runs in the streets.
There’s sound logic behind that advice. Buying on fear works. Here are three reasons why:
1. If you had bought stocks on Oct. 20, 1987, the day after the Standard & Poor’s 500 Index ($INX) crashed by 20.5%, you would have been up 11% in one year and up 52% in two years.
2. If you had bought stocks on Oct. 9, 2002, the day that marked the bottom after the dot-com bubble broke in March 2000, you would have made 33% in a year and 44% in two years.
3. If you’d bought stocks on Aug. 10, 1982, just as the economy started to recover from the strong medicine that the Federal Reserve had administered to cure the inflation of the 1970s, you would have been up 57% in a year and 61% in two years.
And what if you had missed calling the exact bottom? After all, not even the experts can tell exactly when stocks will stop going down.
Well, if you had bought three months too early in 2002, for example, your return in a year from investing in the S&P 500 index would have been just 3% instead of 33%.
But something rather encouraging would’ve happened the longer you held on to your stocks. In two years, the gain from calling it right in 2002 would have been 44%, but the gain for the investor being too early would’ve crept up to 14%. That too-early investment in the S&P 500 would’ve gained 23% in three years, 30% in four years and 56% in five years. That wouldn’t have caught up to the five-year gain of 92% for the person who had invested in the S&P 500 at exactly the right moment. But the gap between 56% and 92% sure would’ve looked a lot better than the 3%-to-33% chasm after year No. 1.
This, of course, is why financial planners tell beginning investors to stay in the market for the long run. Time is the great leveler. It has a way of minimizing the effect of mistakes in timing.
A little at a time
You can minimize the effect of mistakes even more by using a tactic called dollar-cost averaging to build your portfolio. It works like this: Each month or quarter, you put the same dollar amount into whatever stocks you’re using as the foundation of your long-term portfolio. By putting in the same dollar amount, you buy a greater number of shares (since each share costs less) when prices are low and fewer when prices are high (since each share then costs more).
So let’s say that you missed catching the absolute bottom for stocks in October 2002 not by a mere three months but by a whole year and three months. If you’d invested all your money in the S&P 500 on July 8, 2001 — a full 15 months before the stock market hit bottom — you would have a return of just 6% in five years. To put it in dollar terms, $20,000 invested in the S&P 500 on July 8, 2001, would have grown to only $21,132 by July 7, 2006. Why so little? Because being early cost you big. The $20,000 you invested on July 8, 2001, had dropped in value to just $12,960 by the time the market bottomed in October 2002. That gave you a whole lot less in your portfolio when the market began to rally.
What if you been just as early but had bought $1,000 of S&P 500 stocks using dollar-cost averaging every three months starting on July 8, 2001? Well, your gain would have zoomed to 16%, more than two-and-a-half times better. The total value of the $20,000 you’d invested would have grown to $23,285 in five years. And, importantly for many beginning investors, you would have been able to put together this portfolio by saving and investing $1,000 a quarter rather than having to come up with $20,000 in one initial lump sum.
And you would have earned that 16% return even though you started investing during one of the worst bear market declines in stock market history. That’s not an especially scary outcome, is it?
Published Oct. 16, 2008