Some of my readers have asked me if I would be afraid if the market would continue falling to 50% or greater. I’m sure to their surprise, my response has been “I hope so”.
It is human psychology that leads us to believe that buying in a market where prices are up 300% is safer than buying when the market is down 80%. When markets are dramatically up, there is a sense of confidence in the air, when the markets are severely down the confidence is replaced with fear.
If we look at the past decade, many investors missed the chances to buy stocks following the .com crash, 9/11, Tsunami, SARS and now the credit crisis. Many investors I knew felt more comfortable buying Pets.com stock at its height instead of buying Amazon (AMZN) when the Nasdaq crashed 80%.
In addition to my typical look at high cash, low debt, high ROE and high ROI, a few simple rules should be stuck to when buying during a market crash.
1) Stick to big names and blue chips stocks.
2) Find companies that have built irreplaceable business models, distribution, infrastructure, support networks and brand names.
3) Buy low and don’t be afraid to buy lower.
By far the credit crisis is the most globally widespread of the problems we have faced since the Nasdaq crash. If the markets continue to fall, there will be a chance to start building positions in American Express (AXP) that has built an irreplaceable transaction network, or FedEx (FDX) and UPS (UPS), that have built irreplaceable shipping networks.
Pessimism will always pass, and when it does, the stock market will rally back to previous highs and onward to new highs. If you invest in a basket of stocks, there is always the chance that a few will go out of business. You should keep in mind though, that as long as your remaining stock investments recover to previously set highs, you will recover your losses. The discount to previously set highs is your hedge.
Let',s say you buy 10 blue chip stocks at a 50% discount. If 5 go out of business and 5 recover to original levels you break even. If you buy at a 60%, 70%, 80% or greater discount, your hedge grows. At 80% off previous highs, if you bought 10 stocks, 8 can go out of business and if 2 recover you will break even. The odds are squarely in your favor.
As readers have followed along with Raw Greed, investors know that I often recommend stocks when they have fallen 60% or greater and I’m not afraid to recommend buying more to lower your cost basis. Alternatively, if you’re not sure what to invest in during a market crash, buy an index fund.
Remember that a solid company makes a solid investment long-term. The fun of investing is buying at a discount to what you consider fair value. When broad markets sell off its easier to find those opportunities than when broad markets are setting new highs.
*Disclaimer: The author does not own a position in any of the stocks above.