The
experience of investing during the 1970s bear market should give you a few
pointers:
Diversification tends to minimize
your losses. If you invested across several asset classes, your
investment probably did not decline as much as it would have if you
put all your investment into one class. Investing in both equity
(stock) and fixed income (bond, money market, etc.) assets tends to
reduce your loss in a market decline.
The most lucrative stocks can also be
the biggest losers. During bull markets, small cap stocks have
often provided investors with the greatest returns. But as we saw in
the 1970s, they can also account for the biggest losses during a bear
market. We're not trying to scare you away from small cap stocks, or
any investment type, for that matter. But as you've already learned,
high risk and high potential returns go hand in hand. There's another
point to consider. The type of investing we just did -- contributing a
lump sum at the beginning of the investment period and seeing how it
performed, is not the way you invest in a 401k plan. The difference
between putting the entire $10,000 into the market at once and
investing it in smaller installments (as you would invest in a 401k)
is more than just an accounting distinction. It can actually save you
money, as you'll see in our third pointer:
Disciplined investors do not suffer
as much in a bear market. With a 401k plan, you contribute a
certain amount of your salary each pay period to your retirement
investments. With an incremental investment approach, you will always
be buying a batch of assets at the current price. So if, for example,
the net asset value of your mutual fund goes down, you will actually
be picking up shares at a lower price -- and getting more shares as a
result. This phenomenon is known as dollar cost averaging. A
market downturn will affect your overall investment less if you use
dollar cost averaging than if you invested a lump sum all at once.
Let's take a look at what would have happened if, instead of investing
your entire $10,000 up front, you had invested a portion of that money
each month during the 73-74 bear market. The total amount of your
investment by September, 1974, will still come to $10,000, but you
will have been investing regularly, as you would in a 401k plan.
Remember, you will still lose money because the market during this
time did nothing but go down, down, down. But you may be surprised by
what happens with your overall investment.
One final pointer. You can't make
money on an investment unless the investment does well, which isn't
going to happen during a bear market (for example, the S&P 500
didn't recover its full pre-1973 value until 1982). But dollar cost
averaging can reduce your loss during a bear market. With a systematic
investment plan like a 401k, your investments have a better chance
to escape being eaten by a bear.
The
experience of investing during the 1970s bear market should give you a few
pointers: