Averaging Into Stock During A Bear Market Boosts Returns

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Includes: DIA, SPY
by: David Sims

Summary

Timing the market is difficult and averaging in eliminates the need to do that.

If the market is headed for a more serious correction, it is best to spread out purchases over time.

In the long-run, buying stocks is a winning strategy.

Active investors are well-aware of the fact that the stock market has taken a downward turn in the past few months. The Dow Jones dipped 16% from recent highs. The S&P 500 dipped about 15% from its highs around 2,134 last May 2015. The old adage "buy low, sell high" could be applied to this situation. Investors might consider getting a little more bullish.

Fear of loss is likely keeping many away from the markets, but if you have a long time horizon, this might be a great time to jump in. This is especially true if you are dollar cost averaging (more on that below). Using historical examples we can see how investors have faired in each of the past few downturns.

Let's start with the most recent large collapse in the equity markets from 2007 to 2009. The S&P 500 peaked in October 2007 around 1,576 points. By January 2008, the S&P had dipped 15% to less than 1,339 creating a bear market. An investor buying into this market would not have known that a financial crisis was coming. The assumption being that they purchased an exchange traded fund like the S&P 500 SPDR (NYSEARCA:SPY) or the Dow Jones Industrial Average ETF (NYSEARCA:DIA).

In fact, the market bounced around until September when the crisis spread throughout the financial sector. The damage was harrowing with the S&P 500 dropping as low as 667, in March of 2009.

What's the point? An investor with a long time horizon would have been best served to wait this one out (or increase their investment position). By February of 2011, markets returned to that 1,339 level that was 15% below the 2007 bull market high. That was a three year gap where markets healed.

SPY Chart

SPY data by YCharts

From that point forward, the investor would have received a 59% return by simply hanging around in the index at the original buy-in price, 15% below the last high. This is one of the most extreme cases of holding through turmoil, spurred by a crisis that involved lots of leverage.

Going back to the other major market meltdown from the turn of the 21st century, the Dotcom Bubble, we can see that it took more than 5 years for an investor to break-even, if they bought 15% below that market's high.

There have been other 15% drops in the market. Sometimes, the market bounces back with economic growth an earnings expansion. This could be over soon. The point is that it is a difficult thing to forecast.

Dollar Cost Averaging

If an investor is willing to wait for the market to turn higher, they might consider buying a fixed amount of stock periodically at depressed prices to boost total returns. As the market drops, they buy more. When the market moves up they buy less.

Here's a simple example using historical data starting in January 2008, when the S&P 500 had fallen 15% from a recent high.

The investor places up to $1,000 a month into the S&P 500 SPDR ETF for three years. In this example, we round down to the number of shares purchased to create a more realistic evaluation.

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The end result? Averaging into a rough bear market will help you to break-even faster and in the long-run will increase your returns. In this example, the purchases increased returns by 21%, while the market traded down, then back up. It's impossible to predict which direction the market will turn with absolute accuracy.

When averaging into a position, you buy more shares as the price drops and less shares near the top. Overall, your basis is lower because you bought more at a low price.

Disclosure: I/we 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.

Additional disclosure: Averaging into an investment works for mutual funds, stocks, bonds, commodities, and other investments, not just ETFs like in this example.