Be Greedy When Others are Fearful

In periods of high market volatility, fear and uncertainty reign supreme. Investors will panic, letting their emotions take over their rational minds. Reactions will range from staying put and continuing with their original financial plan to withdrawing all remaining assets and vowing to stay out of the markets forever.

A typical reaction by an investor during theses volatile times may be one of the following options:

  • Sell all shares and invest proceeds in GICs
  • Sell all shares and wait one year before reinvesting
  • Hold on to shares with no further investing

But these are unfavourable options when compared with the alternatives. History has shown that in times of financial crisis we should be buying, not selling. Investment billionaire Warren Buffet reiterates this notion when he said that investors should “be greedy when others are fearful and fearful when others are greedy.” We can be greedy by either investing regularly over a given period or investing another lump sum.

When you invest a fixed amount regularly regardless of the unit price, you employ an investment strategy called dollar-cost-averaging. By spreading your investment over a number of periods, you help to guard against the risk that the market may lose value shortly after making the investment with a lump sum. In addition, the investor who makes regular payments of equal dollar amounts will buy fewer units when prices are high and more units when prices are low. But this strategy requires the investor to give up some expected returns for the benefit of reduced risk.

A recent article in the Invesco Trimark monthly magazine, dated October 2008, has shown that investing more will vastly outperform the three alternate options over the long term. In the article, a hypothetical $10,000 was invested in the S & P 500 index at the top of the stock market on January 1, 1973. When the market bottomed out on October 3, 1974, the initial $10,000 had declined by 44% to a value of $5,562. If the investor invested another $10,000 at this time, their portfolio would have grown to an amount of $1,061,649 by December 31, 2007. Alternatively, if the investor continued with regular payments of $1000 a year for 10 years, their portfolio would have grown to $696,128. In comparison, with options 1, 2, and 3, the value of the investor’s portfolio would be $76,450, $258,680, and $379,462, respectively (see figure 1). In addition, the investor who invested another $10,000 or used dollar-cost-averaging will have regained their original $10,000 in 0.42 and 1.33 years, respectively, compared to 6.08, 5.25, and 2.00 years by investors who used options 1, 2, and 3 , respectively (see figure 2).

Graph1
Graph2

Therefore, no matter how bad the financial and world news may be, you should not interrupt your original financial plan or you will lose the benefit of buying some of the units at a reduced price. Stick to your original plan and keep buying even though the prices keep falling and remind yourself that this is just another short term bump in the road to meeting your investment objectives and goals.

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