This post was originally published on this site
Investing at a market top can be tricky, not to mention risky. You hear on a daily basis from the financial media how the major stock indexes such as the Dow Jones Industrial Average and the S&P 500 are setting new highs. It sounds very exciting and makes you feel like you may be missing an opportunity to make some money and get closer to your investment and retirement goals. However, investing in the market during these times may not be ideal. When everyone is bullish and optimistic is exactly the time when you should be skeptical. If you identify as a contrarian or a value investor, this skepticism may come naturally. Either way, it will serve you well. You don’t want to buy when prices are marked up. Getting a bargain and buying when stocks are on sale is much more appealing.
The problem is that sometimes the markets trend higher for long periods of time without experiencing any major pullbacks or corrections. We have seen this with U.S. equity indexes recently. Sitting on the sidelines during a multi-year bull market is not going to help you meet your investment objectives. It can be frustrating sitting on cash waiting for an entry point while everyone else seems to be making money through dividends and capital appreciation. However, it can also be dangerous to invest your hard earned money blindly into an overheated market. The last thing you want is to get a substantial haircut on your holdings shortly after investing.
Do Not Invest All At Once
So there are a couple of things you can do to alleviate the downside risk while also participating in a hot market. For starters, do not invest a relatively large sum all at once. Some financial advisors may advocate putting all available funds to work immediately. This strategy will certainly help the advisor, and may pay off for you if the markets stay hot for an extended period of time. But it can be very risky if some event causes them to reverse course and prices decline. No one can predict the future, so managing risk of loss is paramount to successful investing. It is therefore best to invest smaller amounts of money at a time over a longer time period. If you just invest a portion of your income on a monthly basis anyway, this is generally not an issue. However, if you have a lump sum from an inheritance or an asset sale, for example, it’s best to invest gradually and dollar cost average your way into the market. When you apply dollar cost averaging, you invest the same amount of money incrementally over a period of time. So you buy more when prices are low, and less when prices are high.
As an example, let’s say the stock market is on a tear, and you decide to invest a sizeable inheritance in equal increments on a monthly basis over a period of two years. If the market stays hot, you may miss out on some gains you may have realized had you invested everything in one lump sum at the market top. But you will still earn dividends and enjoy capital appreciation as you invest more and more funds on an incremental basis. If the market then falls towards the end (or even after) your two-year investment period, you will likely have made significant portfolio gains already, which will temper any loss from a potential subsequent pullback. On the other hand, if the investment climate sours soon after you start making your monthly incremental investment purchases, you will still have losses. But they will be much smaller than if you invested everything in one lump sum at the market top. If the market continues to decline, you will be buying at cheaper and cheaper prices throughout your investing period as you invest more and more of the original lump sum. This will help your investment returns in the long term when the market eventually rebounds.
Dollar cost averaging moderates your investment returns. You will earn less than if you invest a lump sum at a market bottom, but you will also lose less than if you invested at a market top. There are many individuals and companies out there who may claim that they have the ability through some seminar or strategy which to allow one to predict future financial market movements. However, most of us already know that it is impossible to predict the future timely and accurately on a consistent and profitable basis. This is especially true when it comes to the stock market, but equally applies to currency, commodity, bond, and real estate markets. No one can predict market tops or bottoms on a consistent basis. The market may be overheated, and you may know that it is ripe for a correction, but you do not know when that will occur. It can be tomorrow or it can be five years from now. Bears have been calling for an end to the current bull market for years, only to miss out on significant dividends and capital appreciation.
Selective Investing and Diversification
Selectively investing in certain stocks or sectors is another strategy which can be implemented at a market top. Just because the stock market averages are breaking records, it does not mean that every stock and sector is performing the same. There are always areas of the market which are experiencing adversity and have not kept up with the averages. This is where contrarian or value investing can be useful. You can invest in stocks or industries, whether directly or via mutual funds or ETFs, that are potentially selling at discounted prices. The opportunity can be company specific or industry-wide.
As an example, many financial stocks are still well off from their multi-year highs due to industry issues. The economy has been weak, interest rates have been low since the financial crisis of 2008-2009, and regulations have been burdensome. Many of these stocks are not enjoying record highs. So maybe you would invest in such stocks expecting a rebound. Energy is another example. A weak economy (reduced demand) and excess supply have been a drag on oil and gas prices, as well as the stock prices of many energy companies. This too may be an opportunity. For easier diversification, you can invest in a sector or industry with niche mutual funds or ETFs.
However, keep in mind that not everything ultimately turns around. Some companies go into bankruptcy or morph into a shell of their former selves. The same holds true for certain industries or sectors. So this is where homework and diversification come into play. You can do research and make educated and well thought out projections and assumptions. However, no one knows for sure what a company or sector will do, just as you don’t know what the market will do or when it will do it. This is why you need to also diversify your investments among and within asset classes.
Investing in a beat-up company or sector which ultimately turns around can offset losses from a general market downturn. So for example, let’s say you invest during a stock market top in a financial stock which has been floundering. It’s been hurt by the financial crisis, burdensome regulations, a weak economy, and low interest rates. All of a sudden, a new administration eliminates some regulations, the economy strengthens a bit, and inflation picks up substantially, causing interest rates to rise. Your financial stock or fund may rise in the face of the general stock market falling, due to the reversal of the factors that were holding it down. That is the essence of how contrarian and value investing can help you to invest generally, and especially during a market top. Yes, initially your beat-up investment can fall even more if the market in general begins a prolonged decline. However, any positive news on your stock or industry sector can result in gains that offset or even exceed any declines caused by a broad market downturn.
So there is no reason to sit on the sidelines while everyone else is celebrating stock market record highs. Just remember to invest gradually by using dollar cost averaging, selectively buy potential bargains using contrarian investing, and just as important, diversify!
Also remember that you do not have to invest in individual stocks if you do not feel comfortable doing so. There are countless actively and passively managed mutual funds, index funds, ETFs, etc. which will also allow you to invest on a value or contrarian basis.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.