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Rule #1 of Investing – Markets Rise, and Markets Fall

by Kevin Mercadante

Whenever there’s a bull market in stocks that goes on for several years, a certain amount complacency sets in. People load up on stocks, and settle back for what they expect will be a perpetual elevator ride to the top. But be warned: Rule #1 of investing – Markets rise, and markets fall.

As much as the ride up feels oh, so good, sooner or later the market will head the other way. And if you aren’t prepared for the reversal, it could be a long, hard, costly ride to the bottom.

It’s not an optimist/pessimist thing

When stocks are rising, investors often prefer not to hear about reversals. They may even dismiss such a discussion as being pessimistic. But the direction of stock market is not an optimist/pessimist thing – it’s the reality of the market, and has been for centuries.

Excessive optimism is the reason why so many people lose so much money in market crashes. Feeling that it is “safe to go in the water”, they abandon common sense and pour ever-increasing percentages of their portfolios into the market. When the inevitable market turn comes, they are completely over-invested. Instead of an age-appropriate asset allocation, they may have 80%, 90%, or even 100%, of their portfolio in stocks.

At the opposite end of the spectrum, excessive pessimism during market downturns is why so many investors miss out on the richest gains. Fearing that the market may drop all the way to zero, they hold all their money in cash, when they should be hunting for bargains in stocks.

A healthy understanding of – and respect for – the fact that stock markets rise and fall is one of an investor’s best assets.

You can’t time the market but…

Market Timing - Markets Ris and Markets Fall

It is a fact that no one can time the market, but that doesn’t mean that timing should be ignored completely in your investment decisions. No one knows what the future direction of the market is, or how far it will go in any direction. But we do have clues.

When the market has been rising for a long time, particularly in record territory, we can pare back our stock positions. This doesn’t mean that you abandon the stock market completely, but that you reduce your holdings from say 80% of your portfolio down to maybe 50%. Not only will this minimize your losses in a major market slide, but it will also allow you to protect a substantial amount of cash so that you can begin buying when the downturn starts looking a bit old.

At the opposite end of the spectrum, down markets are a much better time to find winning stocks. There are a lot of good stocks that have been beaten down by the general downturn, and that creates excellent buying opportunities. It may take more than a bit of guts, but this is the time when you want to begin increasing your stock holdings.

In either direction, it’s about applying the age old wisdom of buy low, sell high. Buy in low markets, sell in high markets. We can do that, even if we can’t time them perfectly.

No matter how well stocks are doing now, have some assets outside the market

Most investors understand and appreciate the value of diversification – that is until a prolonged bull market sets in. With stocks bringing double-digit returns, who wants to be in cash or bonds? But no matter what the level or direction of the market is, you always need to have some money invested outside of the stock market.

Once again, this isn’t simply a matter of lowering your exposure during a strong market, but to make sure that you have sufficient capital to buy heavily should the market take a big hit. Bargain stocks will only be a bargain if you have the cash available to buy them.

Look for value in stocks not trends

Whether we are experiencing a bull market or a bear market, you should always be particularly concerned with investing for value, and not trends. But this is particularly important in long running bull markets.

There is a general belief that you can minimize your losses in a downturn by investing in index funds. But while index funds are an excellent way to invest in rising markets, during declining markets they may offer little protection – they do, after all, represent the market itself. When the market drops, they’ll fall in lockstep.

When a bull market is looking long in the tooth, value will trump all else, at least in your stock holdings. This is when you need to become very selective with your stock picks. Value stocks – stocks that are “out of favor” with the prevailing trends – offer some hope of redemption in a general market decline. Since they haven’t risen with the general market, they’re likely to offer greater resistance to decline than the general market, and greater profit potential on the way back.

Stop living on the financial edge

Like rising house prices, a rising stock market has a “wealth effect” – it causes spending to increase as equity rises. While it’s perfectly OK to enjoy the fruits of your investment success, be careful – especially during bull markets. The higher cost of living created by a bull market could cause a double whammy in a prolonged market decline – the loss of investment equity as well as a decline in your standard of living.

The point is to avoid lifestyle inflation based on high stock prices. That means avoiding taking on higher expenses and a greater level of debt out of the assumption of a permanent bull market.

There are no permanent bull markets – only markets that rise and fall.

Are you taking any precautions with stocks well into record territory?


Published or updated August 5, 2013.
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{ 2 comments… read them below or add one }

1 Cat Alford (@BudgetBlonde)

Good advice. I definitely don’t live on the financial edge. Everything is really conservative, but I wish I could do more. Hopefully in a few years when the hubs is finished with school!

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2 Kevin Mercadante

Hi Cat – Think of now as the time to lay the foundation for your future investing activities!

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