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Recovering From a Stock Market Decline

Written by Nickel - 16 Comments

Did you know that it took the stock market 25 years to recover from the Great Depression? Or that the stock market (as measured by the Dow) made virtually no progress from it’s pre-Bear peak in 2000 until mid-2006? Pretty scary stuff, especially when you consider that the Dow just experienced its third consecutive triple digit loss, dragging it down to a five year low.

As bad as this all sounds, it’s important to keep in mind that the situation would be considerably better if you continued investing throughout the down periods. Indeed, by sticking to your guns and investing in a down market, your “new” money (invested during the downturn) will turn a profit by the time your “old” money makes it back to even. All you need is nerves of steel…

Investing through a down market

Don’t believe me? Check this out… Assume that you invested $10,000 in a mutual fund that cost $100/share. Further assume that you had horrible timing, and the market went south the very next day, resulting in a 50% decrease in share price over the next 18 months. Fortunately, things eventually started looking better, and your investment rebounded to $100/share over the following 18 months.

How would you have performed? Well… If you had:

  • sat tight, then you’d be back to even money
  • panicked and sold, you’d have locked in at least part of your loss
  • bought through the downturn, you’d be ahead of the game

Just to make things a bit more concrete, let’s assume that the price dropped linearly to $50/share during the first 18 months, and then recovered linearly to $100/share over the next 18 months. Let’s further assume that you invested another $10k after one and two years. In other words, your timing wasn’t great, and you ended up buying in about 6 months before the bottom (on the way down), and again six months after the bottom (on the way back up).

How would things look after three years, when the market is finally back to even?

Running the numbers

Here’s a quick look at the numbers:

Original investment: $10,000 @ $100/share = 100 shares
Year one investment: $10,000 @ $66.50/share = 150.375 shares
Year two investment: $10,000 @ $66.50/share = 150.375 shares

Now, in year three, you’re sitting with 400.75 shares at $100/share. Guess what? That’s a total value of $40,075 even though the market has been flat overall, and you only invested $30,000. Calculating your internal rate of return over that three year period works out to an average annual return of 15.10%.

And yet… The market didn’t actually go anywhere. Not too shabby.

While the numbers above are somewhat contrived, and the specifics will vary with things like how far the market falls, how much you invest during the downturn, and how quickly it recovers, the larger point still stands. Regular, consistent investing pays dividends over the long run, even in the face of market turmoil.

Published on October 10th, 2008 - 16 Comments
Filed under: Saving & Investing

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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16 Responses to “Recovering From a Stock Market Decline”

  1. 1
    Rob Says:

    Hmm, starting investing 6 months ago, just before everything bit it? Thats exactly what happened to me. My fund WWNPX is down 40+% as well. And yes, I still plan on investing in it as its down.

  2. 2
    Nicole Says:

    My husband and I are in our mid 20s and see the downturn of the economy as an opportunity to start our Roth IRAs with a little more bang for the buck. We just can’t figure out if we should fully fund 1 or start one for each of us, but most likely not max out either. Any suggestions?

  3. 3
    Brandon Says:

    For the sake of fairness, since you say constant investing, let us look at the opposite effect.

    Shares start at $100, go up 50% in value, then drop back to the original value with 18 months to get to the top and 18 months to get to the bottom just like your example.

    Original investment: $10,000 @ $100/share = 100 shares
    Year one investment: $10,000 @ $133.33/share = 75 shares
    Year two investment: $10,000 @ $133.33/share = 75 shares

    At the end of the period that is $25,000, so you have lost $5000 (20%) while the market has gone nowhere.

    My point is it cuts both ways with constant investing…

  4. 4
    GarvFinancial Says:

    Gaurav here…interesting post…even in a down market you should stick to your guns and maintain the fortitude to whether the storm.

  5. 5
    Tyler @ Dividendmoney Says:

    Brandon has a decent point, which is what most people in their mid-late twenties are facing if they started dollar cost averaging into their employer sponsored 401K’s after college.
    The bright spot is that now these same folks should be hitting the prime of their careers, making more money and able to invest more – which should turn out very nicely for them at retirement time if history is any indication and they stick to the plan.

  6. 6
    Alan Says:

    …yes, Brandon makes a good point.

    Regular investing pays dividends in ’some’ types of market turmoil.

    Take the real-world example of an S&P 500 Index Fund over the last 3 years — and your advice would have caused an investor to lose a third of his money.

    Obviously, there are other significant factors to be considered besides mere ‘regular’ investing.

    Regularly buying winning Lottery tickets is also a profitable investment approach — but it’s a bit more difficult in practice than in general principle.

  7. 7
    Eric X Says:

    How can you say that it’s a flat market when there is a 33% increase (or decrease) between the first and second year ??
    You peeps must have taken notes from Enron !

  8. 8
    nickel Says:

    Eric: It’s flat when comparing the start and end point. The volatility in between is what generates the earnings.

  9. 9
    Brad Says:

    You said “the market didn’t go anywhere”, yet it went from $66.50 to $100/share in your example. Hasn’t the “flat” period in the market been at the $66.50 level? (relatively, not the exact amount)

    That breaks the example since the example requires that the second two investments get a 50% gain ($66.50 to $100 per share). At that rate, people would be pooring money into the market, but it is not doing that.

  10. 10
    nickel Says:

    Brad, re-read the post. I’m responding to the gloom and doom statements about how long it can take the market to get back to even. Simply stated, those that make such claims are assuming that you simply freeze your holdings and what for the recovery, but for people in the accumulation phase that won’t be the case, and you’ll get back to even much more quickly (and/or profit by the time the market as a whole recovers).

    In my example, I specified that you bought in at $100, and that the period in question ended at $100. So over that period, the market as a whole was flat. Yes, it rose from $66.50, but it also fell to $66.50 before that (actually, it bottomed at $50, but I assumed that you didn’t have perfect timing). Nothing about my example is broken — you nailed it on the head.

    If you sit tight and do nothing, you have to wait for the market as a whole to recover. If you sell, you lock in your losses. But… If you continue investing through down periods, that “new” money will go into the market at a relative low point, and will generate positive returns while the “old” money is still struggling to get back to even.

  11. 11
    Brad Says:

    My point still stands. You have to get a 50% increase to go from $66.50 to $100, which is what would have to happen to “regain” the “lost” money.

    It assumes things will go up enough, in a reasonable time frame, to regain the losses and then go farther.

    We have had historically high returns for many years. It is highly likley we will have historically low returns (or losses) to “return to the mean”. That does not paint as pretty of a picture.

    Note your last statement “wait for the market to recover.” If you had your money in the NASDAQ stock index in 2000 (or whenever it was that crashed), you would still be waiting for it to return to where you were. I think it remained down 50% even before the recent troubles.

    Which makes my point. If you had “dollar cost averaged,” on that, you would still be way down. Stocks are not necessarily a good deal with what we are highly likely to face in the next few years, even with such “tricks”.

    IBrad

  12. 12
    nickel Says:

    Yes Brad, and if it were 1933, you’d have to wait 25 more years to get back to even. But the point still stands. No matter how long it takes to get back to even, you’ll be well ahead of even if you keep plugging away. The numbers that I picked were arbitrary and oversimplified, but still illustrate that simple truth. The only thing I’m arguing against in this article is the fear mongering about how long it can take the market to recover after a major drop.

  13. 13
    Brad Says:

    Perhaps it is just fearmongering, but then I suppose someone could argue that the price of tulip bulbs will come back “any day now” too. Our frame of reference is much too short for a lot of the arguments that are being made. (I am not responding just to yours here.)

    Stocks are not the only investment out there, other things do go up in value and it can also be wise to hold cash in such rough times.

    My biggest concern in this is for those who blindly keep it all in the stock market “because it will come back,” rather than considering other options. They could easily end up loosing a whole lot more.

    Hopefully this places my remarks in context. I am not meaning to start a debate here. I just don’t share the same long term excitement for stocks as some. For better or worse, I can get a whole lot better personal return by paying debt down. :/

    Brad

  14. 14
    nickel Says:

    Brad: Thanks for clarifying. Regarding the tulip remark, it’s important to note that the average company (hopefully!) has a lot more inherent value than the average tulip bulb. As for debt reduction, I think that’s a great point, and one that people should always consider when deciding how best to allocate their funds, even when the market isn’t tanking.

  15. 15
    Tck Says:

    And none of this stands the test if you lose your job and have to tap into investments or retirement during the downturn.

    You have to take the loss, because you have to survive. None of the examples talk to this reality. Just ask me, or the folks at Citi.

  16. 16
    francesca Says:

    Dollar averaging and “buy and hold” are used as sales techniques by money managers & firms selling stock funds.

    Stocks as an asset class can go into long term secular declines. Look at Japan. Or the US post Depression and 1966-thru 1970s.

    Following conventional wisdom can get an investor truly burned—while big institutions who market funds collect their fees.

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