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The stock market has staged an epic rally in the last week or so. After briefly being down over 20% year to date (YTD), the Nasdaq Composite is now down less than 10% YTD. Similarly, the S&P 500 and the Dow Jones Industrial Average are both down less than 5% YTD and are officially out of correction territory.
With the market processing rising interest rates, the prospect of lower inflation, and improving geopolitical risks, is now the time to go all-in on the stock market? Or is there a better alternative?
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Be greedy when others are fearful
Warren Buffett, the CEO of Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B), is known for his long-term track record of beating the stock market. But he’s also known for one of the most famous quotes in investing, which is “to be fearful when others are greedy and greedy when others are fearful.” It’s a strategy that tends to keep investors out of trouble, both in recognizing when a stock is overvalued and pouncing on buying opportunities.
In the past four years, there have been three major sell-offs. In late 2018, a brief bear market happened almost entirely in the last three months of the year. Fears over the U.S.-China trade war crushed investor optimism and led to high amounts of fear and volatility. But it proved to be an amazing buying opportunity, as the S&P 500 proceeded to produce big gains in 2019.
The next big sell-off was the spring 2020 COVID-19-induced crash, which also proved to be a buying opportunity that led to massive gains during the rest of that year and through most of 2021. The third sell-off is the one we are still in now. And if history continues to repeat itself, it too will probably prove to be a fantastic long-term buying opportunity.
Expect the unexpected
You may be asking yourself: If now is a good time to buy, why not just go all-in on the U.S. stock market? Well, that’s a bad idea for a number of reasons.
For starters, it’s important to have an emergency fund in case unexpected medical expenses or unforeseen crises emerge. Although the stock market has been a great vehicle for fueling wealth creation over time, no one knows how it could perform in the short term. The market has staged an epic rebound, but it could give up all of those gains for a number of reasons, such as more aggressive monetary policy, a worsening geopolitical situation, or an infinite number of unknowns.
Going hard into the stock market without reserve dry powder leaves you overly exposed to short-term volatility. By putting money to work in the stock market that you don’t need anytime soon, you can take the pressure off of short-term gyrations and keep a level head in case the market sell-off resumes.
A better approach
Yes, it sounds boring. But the best approach to investing is to simply dollar-cost average a portion of your income into stocks over time. That’s the classic advice, anyway. Of course, an investor can operate with a little more wiggle room by keeping a set amount of cash on the sidelines that they only wait to deploy if there’s a truly juicy buying opportunity. In that scenario, it would make sense to begin considering some of the many stocks that are on sale now.
Selectively buying great companies that go on sale is a worthwhile strategy to pair with dollar-cost averaging. In this vein, an investor can harness a sort of hybrid passive/active approach that leaves room for discipline and creativity.
Navigating volatility
Even if the market doesn’t retest its lows and keeps surging in 2022, it is likely to suffer 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 grounded in nothing that has to do with the fundamental business.
Understanding that the market can do crazy, unpredictable things can help keep emotions in check during a stock market sell-off, as well as quell the urge to go all-in, even when it may be tempting to do so.
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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: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.
