It's been a tough month or so for stocks, with the major U.S. stock indexes falling sharply from their earlier highs. The market has been rattled with the threats of tariffs and a growing sense that the U.S. is headed toward more isolationist policies as it pulls back from its allies. Meanwhile, the Atlanta Federal Reserve model is now predicting the U.S. economy will contract in the first quarter after forecasting solid economic growth just a few weeks earlier. That could be the start of a potential recession.
The first thought among investors may be to stop investing in equities or even sell off their holdings and move more toward cash. However, I'd advise against that. Even if we enter a bear market, which is a decline of 20% or more, recent history suggests that they tend to be relatively short. Since 1929, the average bear market has lasted about 9.6 months, which is much shorter than the average bull market, which lasts close to 1,000 days, or 2.7 years. Meanwhile, some recent bears markets have been much shorter. The Covid bear market was sharp but only lasted about a month, while the 1987 bear market also saw a steep -- but short -- decline of only about three months.
Don't try to time the market
Both of those bear markets also preceded some very strong returns quickly after they ended. In fact, new bull markets, on average, see gains of about 25% in the first three months of starting, and nearly 75% of the time, their biggest gains typically happen during the first half of the bull market. This means that even if you correctly time selling off your holdings to avoid a bull market, you're likely to miss the big gains that happen when the market turns.
I've actually experienced this personally, as I decided to sell off half of my stock holdings at the start of Covid because I thought the economic impact could be pretty bad. While I missed a lot of pain in the market, the downturn was so short that by the time I bought back into the market, I was buying back at prices similar -- or higher -- to where I sold. The hard lesson I learned is that timing the market is very difficult.
As such, the best course of action for investors over the long term is to use a dollar-cost averaging strategy, especially in a down market. With this strategy, you invest at regular intervals whether the market is going up or down. The chances of picking a bottom are tough, so this strategy lets you continue to lower your cost basis as the market goes down and sets you up well for when the market rebounds. Meanwhile, the lower the market goes, the more shares you acquire.
In this market environment, one of the best investments for this strategy is the Vanguard S&P 500 ETF (VOO 0.56%), a low-cost exchange-traded fund (ETF) that mimics the performance of the S&P 500 index. The S&P 500 consists of approximately the 500 largest companies that trade on a major U.S. exchange based on market capitalization. It is a market-cap weighted index, which in essence means that the better a company's stock performs, the more important it becomes to the index.
Give this dynamic, perhaps it is no surprise that the ETF's top holdings are, by and large, filled with many of top tech companies. At the end of January, its top five were Apple (7%), Microsoft (6%), Nvidia (5.8%), Amazon (4.3%), and Alphabet (4.2%).
The Vanguard S&P 500 ETF has a great long-term track record, producing an average annual return of 12.9% over the past 10 years, or a cumulative return of 237.4%, as of the end of February. Notably, this period includes two bear markets, one in 2020 during Covid and one that occurred in 2022 that lasted about 10 months.
Image source: Getty Images.
Start small and build
Investors shouldn't be scared of the current market sell-off, and whether it turns into a full-blow bear market is still very uncertain. Like in life, investors can't control the market; they can only control how they react.
It is important to take a long-term approach, not panic, and be consistent using a dollar-cost average strategy. You only need to start with a small amount, but the key to building long-term wealth in any type of market is to consistently set aside money to invest each month. If you start with $500 and were fortunate enough to be able to invest $500 every month and get a 12% average annual return, you would have around $1.5 million at the end of 30 years.
