Most investors today have become accustomed to the idea that stock prices just keep going up. Even when there have been corrections over the past few years, they’ve been retraced pretty quickly on the way to new highs.
Not much time is being spent worrying about the downside of investing in stocks.
Warren Buffett has spent the last several decades explaining why pullbacks aren’t necessarily a bad thing. In fact, investors might even actually want one every once in a while.
In his 1997 letter to Berkshire Hathaway (BRKA +0.63%)(BRKB +0.67%) shareholders, Buffett indicated that long-term investors should hope for multiple opportunities to buy stocks on sale. Only those nearing the withdrawal stage should really be rooting for a rally. Buffett said, “Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
His suggestion is very simple. When stock prices fall, keep buying at discount prices. Don’t give in to the temptation to sell.
Image source: The Motley Fool.
Lower prices can create better long-term opportunities
If you’re someone investing, say, $700 a month into the Vanguard S&P 500 ETF (VOO +0.85%), any dip in the share price gives you the opportunity to accumulate more shares. More shares mean bigger growth opportunities over time.
With VOO trading right around $700 right now, every purchase would buy you one share.
But if the S&P 500 (^GSPC +0.86%) falls by 10%, that same $700 buys 1.11 shares. For long-term investors, those additional shares can experience the same market gains as the shares you bought at higher prices. You just have more of them.
That’s essentially the Buffett argument. The accumulation phase of your investing life should be about buying as many shares as possible. Corrections and bear markets provide better opportunities to pick up more shares.
Since the S&P 500 has historically recovered from every drawdown to establish new all-time highs, those shares bought at lower prices can actually help improve your returns over time compared to if you were just consistently buying at highs.
Market declines shouldn’t be viewed only as losses on your existing investments. They should be viewed as opportunities to capture better prices on future investments.
Today’s Change
(0.63%) $4,755.00
Current Price
$766,000.00
Key Data Points
Market Cap
Day’s Range
$759500.00 – $766000.00
52wk Range
$698000.00 – $806102.81
Volume
159
Avg Vol
181.5
Gross Margin
23.52%
Buffett’s strategy also comes with a warning
For many investors, their first inclination is to sell when stock prices are falling. If the S&P 500 falls by 10%, what’s to say that it couldn’t turn into a 20% or 30% loss?
But Buffett argues that his “buy the dip” strategy only works if you keep investing throughout the drawdown. That’s the only way you can take advantage of market pullbacks.
Here’s an extension of the example from earlier. Let’s say the Vanguard S&P 500 ETF starts at $700 per share, falls to $630, and then subsequently recovers to $700.
Person A bought one share for $700 at the start, decided to hold off on investing further until the S&P 500 recovered, and bought a second share for $700 once the index returned to its previous high. Result: $1,400 invested, two shares owned, $700 average cost per share.
Person B bought one share for $700 at the start, but invested another $700 when VOO dipped to $630. Result: $1,400 invested, 2.11 shares owned, $663.16 average cost per share.
The same path of returns, same amount invested, but different activity. Person A is back to even with a 0% return. Person B is sitting on an overall gain of around 5%. Person A sat tight. Person B took advantage of lower prices.
This is how savvy investors can improve their portfolio outcomes over time. In many cases, emotional decision-making can damage long-term returns. Maintaining a long-term view and staying the course can generate greater wealth.
That’s the real opportunity in Warren Buffett’s advice. Don’t try to predict what the market is going to do. Have a plan in mind before anything happens, and then execute it.
