Index Investing In Down Markets

Posted on April 24, 2015 at 5:13 AM PST by

If the stock market fell 10% in the next week, what would you do? What if it fell 20% in a day? What then?

These seem like wild questions, but it’s a point worth pondering. How would you personally react to a rapid decline in stock market valuations?

If it were a decline like the infamous “flash crash” of a few years back, probably nothing. Really, there’s nothing to do when the market goes straight south and then straight back up before you even notice.

Those events are rare, but what about sharp declines over a few weeks, which happen more frequently? There’s a whole class of “experts” out there who believe that they can see these events coming.

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Called “technical” analysts, they look at complex charts and attempt to find signs of investor psychology in action. They’ll draw straight lines from market tops to bottoms, hoping to convince themselves (and you) that the next move has to be down, or up, or whatever fits their theory.

Problem is, by the time it becomes patently clear which direction the market is going overall, you’ve often already taken most of the hit. Sell now and you lock in the loss. Wait and you might experience even more losses.

It’s a no-win scenario because there’s literally no way to know what the next day will bring, positive or negative. Worse, if you just sit out the market roller coaster in cash, you might miss a big climb in stock valuations, a risk people too often discount.

Index investing would seem to be the perfect way to suffer in all markets, but it isn’t and here’s why: If you own your investments in the form of a portfolio, indexing gives you real diversification while allowing you “wiggle room” to capture gains in both directions.

Sound impossible? Not really. If you buy a portfolio of several asset classes, you can be sure of one thing. More often than not, if one asset class goes up another is going to be flat or go down.

Yes, sometimes both stocks and bonds appreciate. But not U.S. stocks, foreign stocks, emerging market stocks, government bonds, corporate bonds, high-yield and real estate, all at the same time.

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For example, over the past few years foreign stocks were getting pummeled while the U.S. markets have gone higher. What’s happening now? Well, foreign stocks are back in vogue and U.S. stock have flattened.

An index investing strategy that relies on a portfolio approach was positioned to sell off those U.S. gains as they came in and redistribute cash to foreign stocks that were comparatively cheap.

You don’t have to know which foreign firms will have better earnings or worse. All that matters is that you took money off the table and reinvested in real time. Research shows that rebalancing alone can get you 1.5% above the straight stock market return.

Yes, we might have a “down market” ahead of us. Or not. It works out fine if you own a portfolio and smartly rebalance it as those realities become more clear, and do so at the lowest possible cost using index funds.