It's natural in this environment for investors to be reluctant about stocks. Even the best money managers like to have cash available to take advantage of short-term market mispricings. But as difficult as it is in the short term, as markets decline, you should invest more.
Warren Buffett sold out of PetroChina
Now's the right time to get excited
As markets decline, serious investors are excited. The S&P 500 index is down just about 50% from its 2007 highs. Amid all the poorly performing investments, market declines lead to more attractive opportunities. And investing in declining markets, believe it or not, will yield fewer investing mistakes -- because you're far less likely to buy anything at the top.
Investors use research and analysis to find companies that will provide satisfactory rates of return while protecting principal. If you allocate your capital this way, then you welcome declining markets. If the Dow Jones were to suddenly fall to 7,500, you might be 100% invested; conversely, if the Dow were to jump to 15,000, you might only be 50% invested. Consider the following illustration:
You create a portfolio of 10 securities with an aggregate intrinsic value of $100, and your total cost is $50. This portfolio is trading at a 50% discount to your assessed intrinsic value -- giving you a potential 100% rate of return that you'll hope to realize over the next two or three years.
Over the next month, assume that market indexes decline 15%, and your portfolio, being concentrated, slips 30%. Your portfolio is now valued at $35 but intrinsic value still remains at $100.
Your portfolio is now trading at greater discount to intrinsic value. Thus, you have a more compelling rate of return and an even better margin of safety.
As markets decline, sound businesses usually decline with them. As a result, if you can stomach a little volatility, your returns will go up as a result of participating in even greater bargains.
The assumption is that you arrive at an acceptable estimate of intrinsic value and that you only buy securities that are undervalued to begin with. Such undervalued businesses can become more valuable with declining share prices.
Intrinsic value can change
Declining markets do a wonderful job of exposing sloppy, unsustainable business practices of companies that "were caught swimming naked when the tide went out."
One-time mortgage highflier New Century Financial was forced to file for bankruptcy protection. Countrywide Financial seemed headed for permanent troubles until the bailout purchase offer by Bank of America
Another example is in homebuilder stocks. In 2007, Beazer Homes
When your investments decline, you need to be sure that intrinsic value has not been impaired as well. If not, then back up the truck.
Simple but not easy
Watching a continual market decline, day in and day out, wreaks havoc on investors. Get used to it. If you plan on investing for a substantial period of time, you will experience recessions, bear markets, bubbles, and panics. And you will also make some bad decisions. But if you can ignore what the market does daily and focus on what your companies do, you'll find it far simpler to ride out the declines relatively unscathed.
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This article, originally written by Sham Gad, was originally published on Feb. 8, 2008. It has been updated by Dan Caplinger, who has no stakes in the companies mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool has a simple and easy disclosure policy.