Catching A Falling Knife - When And Why You Should

by: Rob_Stein

When the market goes up, it often does so in a slow and painful grind marked by a few steps up, a step or two down, and then another few steps up. But when the market goes down, it often takes the elevator. Declines can be stunningly quick and painful. Several months of hard won gains for the year are easily wiped out in a few days or weeks when the market heads south. Volatility spikes and fear builds. Market chatter quickly goes from: "this is likely a normal, healthy correction", to "this could be the start of a new bear market", and on to "the market is crashing - lookout below".

Many investors, having personally seen and experienced the recent pounding the market took in 2008 - 2009 where the DJIA dropped a whopping 54% (from an intraday high of 14,198 on October 11, 2007 to a low of 6443 on March 6, 2009), quite reasonably fear a repeat of that disaster and the wholesale wreckage done to their retirement and other accounts.

Dow Jones Industrial Average Chart

Dow Jones Industrial Average data by YCharts

So, when the market craters and speeds to the downside, what to do? Two colorful catchphrases you hear when the market appears to be in freefall are: "Don't step in front of this train" and "Don't try to catch a falling knife".

While I understand these sentiments, I think an investor is better served taking the opposite view and using it to profit. How? By stepping in periodically as the market falls to add to favorite positions being taken down not because of any specific company weakness, but because the receding tide is lowering all boats.

Admittedly, this takes some fortitude. And since no one can time the market without absolute blind luck, or pick the bottom, it's likely that any buys on the way down will be early. But if you have an appropriate time horizon (7-10 years) this is really not a problem.

As shattering as the 2008-2009 market pounding was, and as close to a depression as we may have come - it's worth noting that the world did not actually end. In fact, just 4 years after the worst stock market most of us have seen in our lifetimes, we are back at new highs.

Dow Jones Industrial Average Chart

Dow Jones Industrial Average data by YCharts

The people who made money in the last four years were not the ones who got out before the market was crushed and got back in again after March 9, 2009 (no one - at least no one I believe) was that good or that lucky. The ones who made money were those who bought more of their positions at different times and prices on the way down. These folks not only fully recovered on the way back up, they profited handsomely from the buys they made when things looked bleak.

Without doubt, this was difficult to do. It required a basic degree of optimism that the world would not end, and some belief that the pain would eventually pass. When all is said and done, actually catching the falling knife is not really necessary. Simply taking advantage of its movement on the way down is all that's required. No market timing; no special knowledge of where the bottom is. Just a basic belief that strong companies would continue to do business in the world despite whatever difficult times we face.

So, when the market sells off in a big way next time (and it will), what it really comes down to is this: do you think the world is going to end or is an eventual recovery the more likely outcome? If you believe an eventual recovery is the more likely scenario, why would you not invest more as prices drop and companies go on sale?

Scale in over time as the market declines. Do it in small doses as the market makes big moves down. [Plainly, if you do not have the time horizon to wait for a recovery, this strategy is not for you. And, you must have the risk tolerance (ability to sleep at night) for this to work.]

Nothing is ever sure in investing - we try to increase the likelihood of success by tilting the odds in our favor so we win more times than we lose. We are always hearing from one market commentator or another that disaster lies ahead and the economic or financial world as we know it is about to end.

They could be right. But they haven't been so far.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.