It would be better to invest Moreover money following a market drop?
For example, if you were initially investing $ 500 per month, should you double it to $ 1,000 per month once the market has dropped 20%, 30%, etc.?
Logically, this seems to make sense. After all, most of the downturns in the market are short-lived, so buying after a drop is the same as buying at a temporary discount, right? What’s not to love?
Unfortunately, the data only seems to agree in the extremes. For example, going back to 1926, future yields appear to increase only during the biggest downturn (40% or more). We can see this by looking at the one-, three-, and five-year future annualized returns in the S&P 500 broken down by drawdown level (i.e. percentage of all time highs):
As you can see, the median annualized returns at one, three and five years when the market is down> 20% or> 30% is almost identical to the returns during all months. This suggests that there is no additional benefit to investing more when making withdrawals of this magnitude.
However, once the market has fallen by 40% (or more) of all time highs, everything changes. At this point, it appears that the advantage of doubling down is quite large. Notably, after a decline of more than 40%, the S&P 500 tends to return 25% in the next year compared to 13% (in all months) and 12.8% per year over the next five years compared to 11.1% (over all months). This suggests that there is a huge benefit to “buying the drop” during the biggest downside.
But perhaps we should use a time frame more comparable to modern times. Although he regularly relies on data dating back to the 1920s, some have argued that this data is not that useful due to how much the US stock market has changed since then. I see their point. Therefore, I ran the same analysis as above, except this time I started the data in 1988 (I’ll explain why I chose 1988 in a moment).
As of 1988, we can see that there is now an advantage to investing in the S&P 500 after a 30% (or greater) decline in addition to the advantage of investing after a 40% (or greater) decline:
In fact, after a 30% drop since 1988, the S&P 500 has returned 20% in the next year compared to 14% (in all months) and 12.4% per year over the next five years compared to 11.7% (over all months). This suggests that there may be some short / medium-term benefits to investing more following declines of more than 30%, but who knows? After all, a limited time frame from a single stock market doesn’t seem like enough data to determine whether we should invest more following a market decline.
Therefore, I have also performed the same analysis on the All Country World Index ex US (“ACWI ex US”) since 1988, when the ACWI ex US data begins. And, based on the following data, it appears that the advantage of investing following a decline in international equities is even greater than the advantage seen in the United States:
As you can see, in all tested withdrawal thresholds, future returns over the next one, three and five years are higher than those of all other months. If anything, that means buying the drop in international stocks has worked better than buying the drop in the US since the late 1980s.
Given the information above, investing more after a market drop (especially a sharp drop) seems like a no-brainer. I disagree with the data. However, there is a major problem that this strategy fails to address.
The problem of investing “more” after the market falls
So far we have shown that future returns tend to be higher following a broader market decline. This implies that we should invest Moreover money when the markets are in turmoil. But, logical as this strategy may seem, it contains a fatal flaw: it creates money out of thin air. Let me explain.
Let’s go back to the example at the beginning of this article and assume you’re investing $ 500 a month in the S&P 500. Let’s also assume that if the market drops 40%, you’ll double your contributions and invest $ 1,000 a month in the future. My question is where do you get this extra $ 500 a month from?
Do you summon it with a spell? Do you print it at home? You lift it from friends and family?
Seriously, this is the main problem with this “invest more on the downside” strategy. It must have money sitting on the sidelines waiting to be invested to be successful. However, as I illustrated earlier (see here, here and chapter 14 of Just Keep Buying), this will lead to less money Most of the time.
You might argue that you don’t have to have “cash on the sidelines” because you could just cut your spending or increase your income once the market has fallen. Yes, it’s true. However, I would argue that if I could cut your spending or increase your income at some point in the futurethen you could do the same thing right now instead.
After all, why not make these changes now and start investing that extra money today? Statistically, it would be better about 80% of the time and you shouldn’t even wait for a future dip. Obviously, this isn’t as good as investing during a “generational buying opportunity” or telling your friends that you “bought the dip,” but you can’t have it all.
Regardless of what you decide to do, increasing your contributions after a severe market downturn is probably more rewarding than buying in normal times. However, don’t forget that if you can find extra cash during a decline, you can probably find that extra cash now too.
Good investment and thanks for reading!
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This is post 312. Any code I related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data