When the market heads south, many investors panic and make irrational choices. They might buy and sell stocks on a whim, for example, trying to buy at the ideal price.
But this behavior indicates that they're asking the wrong question: when should I invest?
Many investors try their luck at timing the market. And while they're busy making random trades and trying to win big, they'll most certainly rack up large transaction costs and management fees.
Others investors might react by pulling all of their money out of the market completely, missing out on bargains.
The people who make the most of a down market don't freak out when things get hairy. They don't try to predict every single little move the market makes. And they don't take all their marbles and go home, either.
Here are some guidelines and investment suggestions that can help you weather the storm during a down market:
1. Keep Investing Slowly and Steadily
In a down market, people tend to hold off on investments or wait 'until the time is right.' You might be surprised, but that isn't the best approach. In the current economic climate, every day is volatile, which is why the best method is to invest in regular intervals - an investing method known as dollar cost averaging. By doing this, you absorb the volatility and take advantage of share prices while they're on sale.
For example, let's say you have $5,000 to invest in a mutual fund that was priced at $10 per share but has recently fallen to $8. If you go 'all in,' at $8, you might be getting an immediate deal compared to the guy who bought at $10.
But what if the price falls to $5? You've used all of your money and can't get in on the better $5 deal, plus your $8 per share investment has dropped in value. The big assumption here is that the stock will eventually rebound to $8, $10, or better.
Rather than trying to predict the market, the key is to gradually move your money into the market by investing quarterly, or better yet, monthly. That way if stock prices move down, you'll pick up more shares 'on sale' over the months, and when stock prices go up your returns will be magnified.
2. Diversify
Having your portfolio diversified is more important than ever in a down market.
An investment porftolio with proper asset allocation doesn't have money tied up in just one type of investment. Instead, it has a mix of investments which may include stocks, bonds, real estate, cash and other asset classes.
By rebalancing your portfolio, you're effectively spreading your investment dollars across different asset classes to reduce risk -- so you're not putting all of your eggs in one basket. That way no one poor investment in your portfolio has the power to take you down in a down market.
[InvestingAnswers Feature: 'Asset Allocation & Portfolio Management Tips']
3. Cut Your Fund Manager’s Salary
When you invest in mutual funds, make sure to choose ones that have low expense fees. When money is already tight, the last thing you want is to spend more money on fund managers and expenses.
Look for funds with the lowest trading and management fees -- you'll find the fees listed on each fund's prospectus. A good ballpark expense fee is below 0.75%.
If you don't mind investing in index tracking funds, exchange-traded funds are an even lower cost alternative to mutual funds.
[Need help weeding out bad mutual funds? See if it passes the '5 Questions for Finding the Perfect Mutual Fund' test]
4. Ditch Some of Your High-Risk Investments
If you have a long time before retirement, your portfolio probably doesn't contain a lot of bonds, treasuries, money market funds or certificates of deposit, which are famously low-risk.
But if you have less than a decade before retirement, a down market could be a good time to invest in some of these safer, more reliable investments.
They might not offer huge returns, but their stability can help you move toward your long-term goals by avoiding losses as retirement approaches.
Short-term bonds are one low risk investment currently in the spotlight because they are less likely to be affected by interest-rate shifts. And despite the government’s recent credit-rating downgrade, government bonds such as Treasury bills, bonds, notes and inflation-protected securities are still a relatively safe way to invest money.
In a down market, you also want to grow the cash allocation of your portfolio. The easiest way to do that is by investing in money market funds or obtaining certificates of deposit -- both low risk ways to grow your money.
Investing Answer: Down markets are inevitable, but by maintaining a solid financial plan of consistent investment and diversification and by choosing low-cost and risk-appropriate investments, you can come out prepared for the bull market that's just ahead.
