Every investor who buys stocks will eventually experience a market crash. According to data from Capital Group, developed stock markets experience a 5% decline about three times a year. Markets drop by 10% roughly once a year. Extreme crashes of 15% and 20% occur every four and seven years on average.
Stock market crashes happen, and investors have to deal with them. And when I say deal with them I do not mean cashing in just before the market top and getting back in at the market bottom. Consistently predicting when declines will start and when they will end is not possible.
Eventually, market crashes end. If they did not, then a 5% decline would have happened once, as would a 10%, 15%, and 20% decline. Given that declines are not possible to time but do eventually end, regularly investing (including dividend reinvestment) is is a good way of dealing with them.
Averaging the market
If an investor commits to invest a certain sum of money regularly, then they buy fewer units of an index or stock over time while prices are rising. They also buy more units of an index or stock with each investment when prices are falling, until prices turnaround and start heading up again. Think of a market crash as an opportunity to lower the average cost of purchases made during a bull run.
There is something that all regular investment plans do need in abundance and that is time. If a market crash is an opportunity to lower the average cost of purchases, then an investor must invest over the long term to realise the benefits of cashing out at higher prices.
For that reason 10- or 15-year investment horizons are necessary to increase the chances that any significant declines have time to reverse. In addition, having the flexibility to extend the investment horizon is important, just in case a decline is in progress at cashing-out time.
Dividends are not magic, but they can add significant heft to returns when reinvested. Successively more units of an index or dividend-paying stock can be bought when prices are falling. Since each unit gets the same dividend payout, the investor gets bigger dividend payments. These payments, along with the regularly invested sums of money, can be used to buy even more units. A significant number of units can be accumulated over time.
Quality and quantity
If there is one lesson that investors should learn from this market decline it is that diversification matters. It is, in fact, crucial for successful investing. Travel and oil stocks have been absolutely hammered in the last month. Some companies are in real danger of going bust without assistance.
Regular investing cannot help deal with a decline that goes on indefinitely, such as when a company or group of companies goes bust. It is foolish to back a single industry, let alone a single stock. Investing in entire indexes, with an index tracker, is one way to diversify. Stock pickers should find multiple, quality companies that have different business models.
Regularly investing in a diversified portfolio of quality assets is a good way to build wealth. Investing regularly means continuing to buy stocks through both bull runs and market crashes.
James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.