It's so easy to know what to do when stocks crash: Just buy. But now that stocks have climbed out of the cellar, that old familiar uncertainty has started creeping into your mind: Should you buy stocks now, after the market has risen sharply, or should you wait for the next dip?
Obviously, each approach has risks. Buy now, and you could see losses tomorrow. Wait, and you may never get those shares into your portfolio -- and often, you'll see them rise day after day as you sit on the sidelines.
Luckily, there's a simple approach to get the best of both worlds. By using this strategy, you can protect yourself against future stock drops while also reaping some of the benefits if shares rise.
Better by half
Consider an example that many investors are facing right now. There's a stock you like, and you have enough money to buy 200 shares. The stock price has risen strongly in recent months, however, and while you're not concerned that the shares are overvalued, you are nervous that if you buy now, you might be picking up shares at exactly the worst moment. Yet you've been thinking that for a while now, and the stock hasn't stopped going up.
One reasonable option as a long-term investor would simply be to buck up and buy the shares. Sure, they may drop in the short run, but if you think the company's long-term prospects are good, you should end up fine in the end.
But if you're not prepared to invest all your money only to see the stock lose value, then a reasonable compromise is to take a half-sized position. Buy 100 shares now, and if the stock falls later, then you can use the rest of your money to pick up more shares on the cheap. If the stock rises, you won't miss out entirely.
The fraction in action
Investors faced a similar situation back in January. During the New Year's rush to invest, stocks rose dramatically after having hit new lows for the year in November. Between Nov. 20 and Jan. 6, the S&P 500 rose nearly 25%. Investors wanted into the market -- but they had to be concerned about whether the worst was really over.
Of course, we all know what happened next: The market dove, and then just as suddenly turned up. Let's compare how the two strategies did on a number of popular stocks -- with strategy No. 1 being to invest $10,000 on Jan. 6, while in strategy No. 2, you invested $5,000 on that day and then added another $5,000 later if the stock dropped by at least 25%:
Stock |
Value Using Strategy No. 1 |
Value Using Strategy No. 2 |
---|---|---|
Hewlett-Packard |
$9,519 |
$11,150 |
Caterpillar |
$8,408 |
$10,035 |
United Technologies |
$10,283 |
$12,285 |
AT&T |
$9,028 |
$9,514 |
eBay |
$11,779 |
$14,114 |
Dell |
$12,009 |
$14,176 |
Wells Fargo |
$9,274 |
$10,971 |
Source: Yahoo! Finance.
Now obviously, the buy-half strategy won't always work this well. In each case except AT&T, the stock fell enough to trigger the second purchase at a much more attractive price. In contrast, if the stocks had gone up without falling 25%, you'd have made more from the first strategy.
So despite how nicely this particular example worked out, buying half definitely has its potential risks. You may well give up a substantial amount of return by playing it safe. But buying half may be just the ticket to get you to stop procrastinating and start investing. And if only being partially invested keeps you from getting emotional and making a big mistake by selling low if your stocks go sour -- well, the risk of giving up a bit of extra return may be well worth it.
So if you're still on the sidelines waiting for a pullback that may never come, consider the buy-half strategy. It could save you from a lot of future regret.
For more on investing in hard times, read:
- Don't wait: Buy these companies right now.
- Are consumer stocks the right move now?
- This is the easiest money you'll ever make.