The stock market has staged an epic rally over the past week. After briefly falling more than 20% since the start of the year (YTD), the Nasdaq Compound is now down less than 10% since the start of the year. Likewise, the S&P 500 and the Dow Jones Industrial Average are both down less than 5% year-to-date and are officially out of correction territory.
As the market deals with rising interest rates, the prospect of lower inflation and improving geopolitical risks, is now the time to bet on the stock market? Or is there a better alternative?
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Be greedy when others are afraid
Warren Buffett, CEO of Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B), is known for its long track record in beating the stock market. But he’s also known for one of the most famous quotes in investing, which is “to be afraid when others are greedy and greedy when others are afraid.” It’s a strategy that tends to keep investors out of trouble, both by recognizing when a stock is overvalued and by seizing buying opportunities.
In the past four years, there have been three major sales. At the end of 2018, a brief bear market occurred almost entirely in the last three months of the year. Fears over the US-China trade war have dashed investor optimism and led to high levels of fear and volatility. But it turned out to be an incredible buying opportunity as the S&P 500 continued to produce big gains in 2019.
The next big sell was the COVID-19 induced crash in the spring of 2020, which also turned out to be a buying opportunity that led to massive gains through the rest of this year and most of 2021. The third sale is the one we’re still in now. And if history keeps repeating itself, it too will likely prove to be a fantastic long-term buying opportunity.
expect the unexpected
You might be wondering: if it’s time to buy, why not just go all-in on the US stock market? Well, that’s a bad idea for a number of reasons.
To begin with, it is important to have an emergency fund in case of unexpected medical expenses or unexpected crises. While the stock market has been an excellent vehicle for fueling wealth creation over time, no one knows how it might perform in the short term. The market has staged an epic rebound, but it could forgo all of those gains for any number of reasons, such as more aggressive monetary policy, a deteriorating geopolitical situation, or an endless number of unknowns.
Going hard into the stock market without reserve dry powder exposes you too much to short-term volatility. By putting money to work in the stock market that you don’t need anytime soon, you can relieve the pressure of short-term fluctuations and keep a cool head in case the market sells off again.
A better approach
Yes, that sounds boring. But the best approach to investing is simply to dollarize the average of some of your stock income over time. That’s classic advice, anyway. Of course, an investor can operate with a bit more leeway by keeping a fixed amount of money in margin that they only wait to deploy if there is a really juicy buying opportunity. In this scenario, it would make sense to start looking at some of the many stocks currently on sale.
Selective buying of large companies that are put up for sale is an interesting strategy to combine with the cost averaging. In this vein, an investor can exploit a sort of hybrid passive/active approach that leaves room for discipline and creativity.
Even if the market does not retest its lows and continues to climb in 2022, it is likely to experience more corrections and bear markets in the years to come. Timing the market is difficult, and short-term price movements can be random, confusing, and based on nothing to do with fundamental activity.
Understanding that the market can do crazy and unpredictable things can help control emotions during a stock sell-off, as well as quell the urge to go all-in, even when it might be tempting.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool owns and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.