The markets have been dealt a small dose of realism this past week. It turns out markets don’t go straight up all the time.
Small Cap Indexes like the Russell 2000 have taken the brunt of the selling and are down about 10% from their highs.
Large cap indexes like the S&P 500 are down about 3% from their record highs.
This “sell off” has already led to the fear inducing headlines from the financial media, as seen below.
But a lot of smart investors would argue that this is exactly the OPPOSITE reaction you should be having.
All of this got me thinking, why are we so quick to get in a panic over a stock market sell off?
A person who is going to be a net buyer of stocks for the next 30+ years should PRAY for lower stock prices.
Of course, I’m hardly the first person to have this view. Some of the best investors in history have been very vocal about the need to celebrate rather than panic over the next stock market correction. One of those is our Quote of the Week:
In his commentary of Chapter 8 of The Intelligent Investor, Zweig describes this channel further:
…the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume – the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in weeks and months to come.”
Not quite what you get from the CNBC’s of today is it?
Why is this so? Should you really be cheering the next time the market falls?
For an example let’s say you are 30 years old, have $5,000 to invest into a ROTH IRA, and you want to invest that money into shares of Coca-Cola, which are currently trading for $42 per share
Would you rather purchase those shares for $35 or $42?
Of course this one is easy, $35 is the answer.
But here is the scenario that trips up most investors:
Once again you have $5,000 to invest and want to purchase Coca-Cola stock, but this time you also already own $10,000 in Coca-Cola stock that you purchased for $45 earlier in the year.
Now, would you rather see Coca-Cola stock drop to $35 a share, where your $5,000 could buy about 140 additional shares? (But, keep in mind this scenario also sees your current $10,000 investment drop in value to about $7778)
Or, would you rather the price of Coca-Cola shares rise higher, say to $50 per share, where your $5,000 investment would buy only 100 additional shares? (But, your current $10,000 investment would have risen in value to about $11,100)
For many, the thought of seeing their investment balance drop haunts them, so the constantly cheer for rising stock prices.
However, those share prices only matter the day you buy and the day you sell your shares, what happens in the middle means nothing.
Consider 30 years from now Coca-Cola’s stock price is $250 per share (which would be the case for a 6% annual return for the next 30 years from today’s price).
If you purchased that stock at $35 per share, your return on that purchase is about 614%
If you purchased that stock at $50 per share, your return is about 400%
What happened in between doesn’t matter, all that matters is the price of the stock at 2 specific times. The time you buy, and the time you sell.
The investor who saw the drop in Coca-Cola’s share price as an opportunity instead of misfortune stands to benefit much greater when the market recovers.
In the long term, having Coca-Cola temporarily drop to $35 so your $5,000 investment purchases more shares is much more beneficial, even though it means you have to look at a “paper loss” on your original $10,000 investment until Coca-Cola bounces back.
Any long term investor should want to see a quality company like Coca-Cola drop 10%. You should be dreaming about high quality companies dropping 20% or more.
In our posts this week, we are going to explore the idea of celebrating market sell offs much further. To start, tomorrow we are going to look at how investors like yourself actually benefit from market sell offs, and later we will look at specific historical examples of investing through previous stock market panics, and how different strategies would have played out.
