With the S&P 500 index dropping over 10% in just the last three months, investors received a not-so-subtle reminder of the perfectly normal declines that occur in the market.
According to Compound Capital Partners, the S&P 500 index sees intra-year corrections of 10% almost every other year and 20% drops every four. On top of the broad market’s decline, the technology-focused NASDAQ Composite index dropped over 15% year to date, and many investors have felt the pain — myself included.
Thanks to this broad sell-off and owning a portfolio that skews toward tech-focused businesses and cryptocurrencies, I have watched 25% of my retirement savings evaporate in just months.
So why is this just fine?
Let’s look at three specific reasons, or steps, that I take to help keep me steady financially, and perhaps more importantly, psychologically — allowing me to find optimism and seek opportunism in hard times.
If you can, keep buying
Dollar-cost averaging may be one of the most potent investing forces in the world, outside of compound interest itself. By setting up my retirement portfolios to receive cash every Monday and Wednesday, I commit to adding to some of my favorite businesses, regardless of market conditions. The main benefit of these consistent additions is to remove any guesswork on trying to time the market on my end.
I’m not a technical trader by any means, so there’s no reason for me to do anything other than make consistent, methodical purchases of businesses I love.
I don’t know what the market will do in the short term — I never will. But I do know that when investors lengthen their holding period for stocks, the probability of their returns being positive only continues to grow.
With that said, as long as investors have excess cash they don’t need within the next five years, it’s vital to continue putting it to work across a variety of price points in high-quality businesses.
Let compounding returns go uninterrupted
Both of the most significant investing mistakes of my life came from simply interrupting the power of compounding returns.
In 2014, I sold Amazon in the low $300s per share. Why? I resented the idea of a Fire phone — so much so that I didn’t want to own one of my generation’s most promising-looking growth stocks anymore.
This short-term thinking interrupted compounding returns to the tune of nearly 1,000% over the next eight years or so. Worse yet — I was right. The Fire phone proved to be a disaster and ceased existence quickly. However, Amazon almost immediately returned to its market-crushing ways, but I had already interrupted my participation in those compounding returns.
Similarly, in 2018, I sold Shopify for around $150 a share — a quick three-bagger on my cost. This expensive-looking stock was easy to let go of to raise necessary cash for a bad situation in life I hadn’t prepared myself for with a tangible emergency fund.
Once again, I interrupted the compounding process. My lack of financial preparation forced me to exit a position in a company that would now be a 10-bagger, even with its recent sell-off.
Long story short, life is wildly unpredictable. Therefore, it’s vital to build an emergency fund, only invest cash you can’t imagine using in the next five years, and leave your winners alone.
Reframe a bear market as an opportunity
While it can feel selfish to say with bear markets delaying and affecting millions of retirement plans globally, extended downturns are advantageous for investors not immediately facing retirement. Provided we are still dollar-cost averaging consistently and only using excess cash we won’t need soon, these lower prices will drive future outperformance.
These are the times when we can finally buy great businesses at fair valuations. For example, consider this chart, which shows the price-to-free cash flow ratio for two of my favorite companies.
Adobe (NASDAQ: ADBE) and ASML (NASDAQ: ASML) have massive free-cash-flow margins of 40% or more and grew annual sales 23% and 33%, respectively, in their most recent full fiscal years. However, they still heavily sold off in the last six months.
While price-to-free cash flow multiples of 29 and 21 aren’t necessarily cheap by traditional valuation methods, they certainly look cheap compared to each company’s five-year growth rates of 22% annually. Anytime a company’s revenue growth rate approaches, or is above, its price-to-free cash flow ratio, it catches my attention, highlighting a discounted price on that growth.
Ultimately, these two stocks are perfect examples of why downturns can be present an opportunity for your portfolio. By continuing to dollar-cost average, you can capitalize on attractive prices for some of the most robust companies in the market.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Josh Kohn-Lindquist owns ASML Holding, Adobe Inc., Amazon, and Shopify. The Motley Fool owns and recommends ASML Holding, Amazon, and Shopify. The Motley Fool recommends Adobe Inc. and recommends the following options: long January 2023 $1,140 calls on Shopify and short January 2023 $1,160 calls on Shopify. The Motley Fool has a disclosure policy.