The Market Answers Our Prayers

For some of us, anyway

By Kaye A. Thomas
Posted July 7, 2008

Accounting for Active Traders

Schedule D made easy

How a drop in the stock market helps.

There it is on page 61 of William Bernstein's brilliant (but difficult) book, The Four Pillars of Investing: Lessons for Building a Winning Portfolio: "A young person saving for retirement should get down on his knees and pray for a market crash." How on earth does that make any sense?

Two reasons. The simpler one is that a market decline allows you to build your retirement fund with stocks bought at lower prices. The advantage for long-term investors is clear. The recent decline doesn't qualify as a crash, but you're a lot better off adding to your stock portfolio at today's prices than at the levels in effect last October, when the S&P 500 was more than 23% higher than it is today.

A more subtle reason is that a decline in stock prices means, other things being equal, an increase in the dividend rate. If you reinvest your dividends, your stock portfolio will grow more rapidly when the dividend rate is higher.

Stay the course

People who stop adding to their stock portfolio because the market has gone down or, worse still, sell because of a decline, won't reap these benefits. That's a buy high, sell low approach, one that has never been known to succeed. A stock market decline is an opportunity to buy, not an indication you should be selling.

I imagine there are plenty of people in their 20's and 30's and 40's looking at the smaller balance in their 401k accounts and other portfolios with regret when they should be celebrating. Sure, it would have been nice to have made your prior stock purchases at lower prices, but that's water under the bridge. In the long run this decline in the market will work to your advantage, improving your ability to accumulate wealth — but only if you stay the course.

The market's decline can be painful for people close to the start of their retirement, producing an unwelcome change in their standard of living. This is why many experts recommend a reduced exposure to the stock market as retirement approaches.

For the rest of us, the difficulty is psychological, not financial. I'll quote William Bernstein again: "By some strange quirk of human nature, financial assets seem to become more attractive after their price has risen greatly." And the reverse is true as well. One of the marks of a successful investor is the ability to see a decline in prices as an opportunity rather than a misfortune.

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