Free Ebook.

Enter your email address:

Delivered by FeedBurner

« Most Teens Expect to Be Wealthy, But Have Little Knowledge to Make It Happen | Main | What People in Their 40's Own, Owe, and Are Saving (And Where I Stand in Comparison) »

April 10, 2007


Feed You can follow this conversation by subscribing to the comment feed for this post.

"To me, it's a way to buy something I believe will go up (and I have history on my side to back this up) at a cheaper price than what I'd be willing to pay"
That's not true. You don't know if you have history on your side. You don't know that *if the stock market hadn't dropped* we'd be at the same place today. You may think that we have ended up in the same place, but you can't tell. For instance: imagine three periods where the market starts at 10, drops to 5 and rises to 15. You buy 5 worth of stock at time two and see a triple. Now, imagine the market starts at 10, stays at 10, and then goes to thirty. Once again, you get a triple from period 2 to 3. Unfortunately, you have no idea which of those two cases actually played out. Pick up "Fooled by Randomness" and read carefully the sections on the "invisible histories."
I like your thinking (save save save) but to think that you should defer savings to buy when the market goes down is 100% against the logic of efficient markets (and 100% against the logic of the index funds you espouse continuously).

When I say "defer savings" I of course mean "defer investing" (a form of saving).

I also just realized in my haste I completely screwed up my example. But my statement stands: there is no reason to defer investing because you want to take advantage of a downturn in the market.

Kurt, that's not entirely true.

1) The key here is that, the short term movements of the overall market should have no impact on where the stock market will be in 20 years. So if something is worth $1 million in 20 years, would you pay for it with 150k or 200k?

2) What is being suggested here is not against the efficient market hypothesis, or why we should invest in the index fund. Suppose you have a diversified portfolio of cash and stocks, as it seems to be suggested in this case. (Let's ignore other investments such as bonds here, but the same applies) If your target asset allocation is 60% stocks and 40% cash, then when the stock prices drop, stocks are represented less in your portfolio. To expose yourself to the same amount of risk, you rebalance your portfolio by transferring some of your cash to stocks.

Two things to point out with #2.
i) If cash and stocks have the 0% return but have uncorrelated ups and downs, you can still "make" money just by buying stocks when stocks are cheap and selling when they are high. (Judged by how many percentage of stocks you have in your portfolio)

2) This is part of the reason why diversification is good. Rebalancing your portfolio to meet your target allocation is a way to give you a higher Sharpe ratio than putting all your money in one asset.

Of course, how you determine your target allocation is a completely different topic.

What? Giving in to market timing now? What was that cash doing on the sidelines anyway? I agree, but I would wait for evidence it will rise or at least has bottomed. Bad days tend to be followed by bad months.

It's not really true that bad days are followed by bad month. That sounds more like market timing to me.

Bad days usually result in higher volatility.

There are a lot of reasons for holding cash instead of investing it in the stock market. If you need to buy a house within a year, why would you still have your down payment in the stock market?

Again, it's down to asset allocation. That depends a lot on your time horizon.

"Kurt, that's not entirely true.

1) The key here is that, the short term movements of the overall market should have no impact on where the stock market will be in 20 years. So if something is worth $1 million in 20 years, would you pay for it with 150k or 200k?"
My point is that you DON'T KNOW. You can say that it will be at the same point in 20 years, but how do you know that? You only witness one history (the one that happened). Besides, if what you say is true (and enough people believe it) the situation won't arise in the first place. You can say that short term movements do not affect long-term performance until you are blue in the face, but the fact remains you have no way of discerning that. I could just as easily say that the future market levels are going to be 1% lower in 2050 after the 1% drop in the market today. You just can't tell, and to say that we should keep money on the sidelines in the hope of buying on dips is really misguided.

I think people are taking this too literal - you don't just buy up stock that dropped in price, you buy stock that drops in companies that more than likely have a rebound - if there is a rumor of bankruptcy or closing the company, you aren't going to snatch it up.

However - if it's going to be bought out, that'd be something worth grabbing (TMU).


You're right that nobody can know for sure. The way you say nobody knows for sure it's close to saying nobody knows anything for sure.

Anyway, the original analogy still stands. If you are willing to buy the toilet paper when it's on sale, you should buy into index funds when they get cheaper.

You can say that the 15% off on toilet paper will reduce the price of toilet paper in 20 years from now. Nobody knows "for sure" (as in 100% confidence). To me the argument just seems silly.

"Anyway, the original analogy still stands. If you are willing to buy the toilet paper when it's on sale, you should buy into index funds when they get cheaper." My point is that if you like it before it "goes on sale" you should have already purchased it and therefore had no (additional) money to spend on the "sale." There is abundant evidence that market timing doesn't work, and that's all this is.

If you read the comment that I posted above, I mentioned how this can fit into the framework of asset allocation.

Rebalancing your portfolio is not market timing. You are allowed to have money elsewhere, instead of putting all your money in stocks.

You can work out the math to see that setting a target allocation helps you buy stocks "on the cheap", even if the movements of the stock market is random.

It's not really true that bad days are followed by bad month.

Statistically, there is an increased likelihood. The reason is correlation to underlying economics. Good days are more frequently followed by neutral months. You may not wish to act on the probability, but it exists.

Really, where does that statistics come from?

I would seem like it's something that can be exploited by hedge funds if that is true.

I only know that volatility goes up after the market goes down. (A negative correlation between stock prices and its volatility)

I looked at Bayesian statistics of the historical Dow from Yahoo Finance in Excel. Uncertainty and trading costs make it uneconomic. After all the stock market has predicted 9 out of the last 5 recessions. Actually I believe it has been exploited by hedge funds which is why we see lower volatility than in the past. Still trading on the 200 day moving average is almost breakeven which does spell a better risk adjusted return, though not a better absolute return. This was from some Penn. professors work on technical trading. Selling after a drop is a little late, but delaying a purchase can be warranted.

I'd just like to say that this article is perfect timing since it day one day BEFORE today's downturn. I think there might be another few trading sessions before things will try to bounce back so people should buy more if they believe in the long term prospects of the global equity market.

I do the same thing and I've been advocating the same strategy in my own blogs recently. When stocks go on sale I always buy. Good tip and many would do well to heed it. (that's me)

I find myself on the same page as FMF. This must not be about SS. :)

Advisors, including Bernstein, recommend buying stocks "on sale". Or reallocating some bond money to stocks when the risk factor for stock drops (because the price has dropped). This is sometimes referred to as Value Investing.

On the other hand, I'd not quite call the current market prices "on sale". Compare the PE, PB, and dividend rates to the valuations that Bernstein and Bogle use. The market is still highly valued. It's impossible to say for sure, but ten year returns are likely to be lower than normal until the market drops more.

The comments to this entry are closed.

Start a Blog


  • Any information shared on Free Money Finance does not constitute financial advice. The Website is intended to provide general information only and does not attempt to give you advice that relates to your specific circumstances. You are advised to discuss your specific requirements with an independent financial adviser. Per FTC guidelines, this website may be compensated by companies mentioned through advertising, affiliate programs or otherwise. All posts are © 2005-2012, Free Money Finance.