The Simple Strategy That Improves Your Returns

Buying when everyone else is selling takes a lot of discipline. But even if you miss the bottom, you don't have to have perfect timing to profit in down markets like this one.

In the face of double-digit declines in all the major stock market indexes this year, many investors are questioning whether their asset allocation strategies make sense. Especially for those who already own a lot of stocks, the losses have really hurt -- badly enough that you're probably tempted to get out entirely, or at least stop adding new money to the market.

Yet ignoring the opportunities that the market gives you at times like these can be costly. As you'll see below, being opportunistic when other investors are rushing to the exits can enhance your returns even above what you'd earn just by making a monthly investment to a stock or mutual fund.

Waiting for safety
Of course, if you could time your purchases perfectly, you could obviously make tons of money buying each time the market hit lows. But in reality, many investors don't buy those dips. Instead, they wait for an all-clear signal before investing. Often, waiting means they miss the low by a big margin.

Consider, for example, some of the false alarms that investors have seen in the past year. Back in January, an abrupt, large cut in interest rates by the Federal Reserve promised to reinvigorate the economy. In March, the collapse of Bear Stearns and its subsequent purchase by JPMorgan Chase (NYSE:JPM) suggested problems on Wall Street might be over. In mid-July, the Fed tried to offer new financing opportunities to Fannie Mae and Freddie Mac -- to no avail. And just last week, the government announced its biggest efforts yet -- a rescue of AIG (NYSE:AIG) and a $700 billion bailout of holders of mortgage securities. Days after each of these episodes, stocks were trading significantly higher.

So does waiting a bit after a new low wipe out the advantage of buying in times of crisis? To find an answer, compare two strategies. In one, you put $800 into each of five stocks and an S&P 500 index fund on the first trading day of each month from January to September. In the other, you invested $1,800 shortly after those four key events. Here are the results:

Source: Yahoo Finance. Key-low investments were made 1/29, 3/24, 7/22, and 9/19.

Slow and steady loses the race?
Those who are familiar with the concept of dollar-cost averaging would probably expect to see regular monthly investments outperform someone who missed the lows following these adverse events. After all, by missing the lows, investors end up paying more for their shares -- in some cases, quite a bit more.

Nevertheless, despite that handicap, you would still have done better capitalizing on those downturns than with your regular investment program. And notice that this is true even though the markets still haven't rebounded. Overcoming your fear and buying stocks when everyone else is running scared can really help you outperform.

A low that never comes
There's a big problem, though. If you always wait for a new low before you invest, what happens when there isn't another one for months or years -- or ever? While someone making monthly investments will continue to put more money in and reap the benefits of the next bull market, you'll be stuck with your money on the sidelines.

To give yourself the best of both worlds, combine the two strategies. Make a regular monthly investment to ensure you'll add new money no matter what happens. But also keep some extra money ready to take advantage of unexpected opportunities. That way, you won't find yourself without the cash to invest when your favorite stocks give you the bargain of a lifetime.

For more on investing in tough times, read about:

• How to face the next Black Monday.
• Why picking the absolute bottom doesn't matter.
• One reason why selling now might actually make sense.