A Question Worth Billions and Its Answer
Every time markets crash, some watch their wealth melting down and some others see an opportunity there.
The most recent type of coronavirus disease, the so-called “COVID-19”, has hit the world really hard! Starting from its major impact on people’s health that has led to the death of thousands of people, it also affected travel, commerce, education, production, socialization, working habits, and many other areas of daily life.
In a very globalized and interconnected world, of course, the financial markets have also had their fair share. All index funds from Dow Jones to S&P 500, European stock markets to all Asian financial assets have collapsed. Even the possible safe heaven commodities; gold, silver, oil couldn’t resist the worldwide meltdown. Cryptocurrencies were standing their ground to act as the new safe haven, but it also couldn’t resist further and most of the cryptocurrencies have collapsed around 40% in a single day.
When the S&P 500 Index value has seen the historical top of 3,393.52 Dollars on the 19th of Feb 2020(Marketwatch, 2020), markets have started falling down with the fears of coronavirus and long-expected recession expectations combination and have been crashing since then.
While the trillions of dollars are being wiped out of the market every day in the last few weeks, some people have evaluated the falling prices as an opportunity to buy the assets cheaply. However, to be able to make money in such a market, there is actually a question worth billions that you need to answer first: When and at what price to buy the dip?
S&P 500 has seen a negative close for 12 days in the last 18 days and its value is 729,8 dollars lower from its all-time high on the 19th of February. If you have tried to buy the dip with all your money in any of these days, then you’ve most likely lost some capital trying to catch a falling knife, and believe me you’re not alone trying this. Not only retail investors but also hedge funds, investment banks, small family offices are all looking at the optimal price to go back into the game if they haven’t been just staring at the fall with all their capitals already invested. If these investors tried to catch the bottom in any of these 12 days, they may have invested at $3341.02(Close price at 20th of Feb), $3116.39(Close price at 26th of Feb), $2746.56(Close price at 9th of March) or really managed to catch the bottom of the month to date at $2480.64(Close price at 12th of March). Even in the case that the bottom of the month has been caught, there is no guarantee that the price will not go any lower next week, so you’ll still be at the sideline staring at your wealth melting down and cannot do anything about it. Therefore, even the Oracle of Omaha and the world’s 3rd richest person Warren Buffett believes that
Trying to time the market is a waste of time and hazardous to investment success (CNBC, 2018).
Here is the secret solution to all your problems: Dollar-Cost Averaging (DCA)!
Dollar-cost averaging is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase(Investopedia, 2019). So instead of predicting the market bottom, you’re buying with the piece of your allocated money each time the price drops a little more. If you have purchased a piece exactly at the prices given above at $3341.02, $3116.39, $2746.56, and $2480.64, your average cost of investment was going to be (3341.02+3116.39+2746.56+2480.64)/4 = 2921.15 dollars. When you look at this equation, dollar-cost averaging puts you in a place that is only better than 2 of the 4 prices you could have all-in, but if the price keeps going down and you keep buying, you may lower your average even below $2480.64 which was the lowest price possible in our scenario and that would put you in a better position than all 4 out of 4 cases. If the price turns around before you lower your average to the point you desire, it’s also OK, since the rise in the price will turn your profit to positive figures anyway.
If you look at the market crash during the 2008 financial crisis, you’ll see numerous amount of dips that you could have tried catching between top $1580 and bottom $675, in which case you could have been wrong numerous times. However, if you kept dollar-cost averaging during this crisis until the bottom, then you would more likely to turn your balance positive when markets have started going up from here a lot earlier.
If you decide to follow this strategy while investing, there are some key points you need to be careful about!
- Don’t panic
- Use the money that you won’t need in the medium term (3–5 years)
- Once you’re done with all the allocated amount, stop checking the prices
- In the times of crashes, don’t try to invest in penny stocks or shady companies
Don’t panic is a rule that is not solely specific to this investment strategy but to all strategies in the financial markets. If you have a strategy, follow it without involving your emotions. If your strategy stops working after a couple of attempts then revise your strategy, find what you’re doing wrong, fix them, then start following your new strategy, but never panic!
Using the money that you won’t need in the medium term (3–5 years) is especially important in this strategy because you really don’t know where the market will bottom and if you need that cash before the market turns around, then you may have to cash out at loss.
Once you’re done with all the allocated amount, stop checking the prices, because when you start buying you need to divide your money into equal amounts to dollar-cost your investment, but if you have bought in each bottom and the market kept falling down, then it’s wise not to check the prices everyday to torture yourself. In order to avoid this pain, what you may do is to keep the last piece of your allocation as long as the market keeps going down, so you’ll still have some money in hand later to lower your average even more.
In the times of crashes, don’t try to invest in penny stocks or shady companies. Instead, try the blue-chip stocks or reliable index funds. If the company has not proven itself to be consistently successful, operational, and profitable, it may never turn the things around and the prices may go way lower than your average cost.
Nobody currently knows how low the current markets will bottom. Is it a correction on a bull market, or are we in a bear market already? It won’t be any good to you, if you rush things and buy the first cheap asset you come across thinking that the markets will all turn green tomorrow. It’s always good to have some cash aside to be ready for all possibilities. Make your research well before investing in anything and don’t forget that
this is a strategy that will only work, if markets really turn around and starts going up at some point.
Be safe out there!
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Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. Use this information at your own risk.
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