The Dow Jones Industrial Average (DJINDICES: ^DJI) has seen two drops of more than 1,000 points in just a single week, taking the average down more than 10% from the all-time high it set in January and officially marking a stock market correction. While some investors are panicking over the market's decline, smart investors are looking for ways to profit from it.
It's natural to be nervous about putting money into the market during a big drop. You may be concerned that after you invest, further losses could test your resolve and lead you to make big mistakes. In that case, the three strategies below can help you maintain your discipline no matter what the future brings.
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1. Dollar-cost averaging
Many people use the dollar-cost averaging strategy without even realizing it. With this strategy, you invest a fixed amount of money on a regular basis into shares of a stock or mutual fund. 401(k) contributions are an automatic form of dollar-cost averaging, as you invest a set amount with every paycheck. Making regular deposits to a mutual fund or brokerage account is another, more manual way to dollar-cost average.
The reason why dollar-cost averaging works well during a correction is that when stock prices fall, your fixed dollar amount buys more shares, and that's exactly what you want to do when share prices are cheap. Dollar-cost averaging automatically helps you take greater advantage of corrections by purchasing more shares than you could have before the drop in price.
2. Invest some now and some later
Many people have kept substantial amounts of money in cash during the most recent bull market, concerned that a market crash was imminent. You can never be sure whether a correction will lead to a full-fledged bear market (which involves declines of 20% or more) or to an rebound that takes the market to new highs. If you invest everything you have now and get it wrong, further declines could be especially painful.
One simple solution is to invest just a portion of your available money right now, with the expectation of putting more money into the market in the future. How exactly you set this up depends on your risk tolerance. Some people like to establish time-based milestones. For instance, you may decide to invest a third of your cash now, another third three months from now, and the final portion six months from now. Others tie their future purchases to the levels of the stock market, perhaps investing a third of their money now with the intent of investing another third if the market falls 20% and the remainder if it falls 30%.
There's no one-size-fits-all solution, and you can make things as simple or as complicated as you want. The goal is to be comfortable with whatever you do so that if share prices keep falling, you won't have a costly emotional reaction that threatens to ruin your investing strategy.
3. Give your savings an extra bump
Finally, if you're able, consider boosting your savings temporarily during market downturns. For instance, if you invest 6% of your salary in a 401(k), think about bumping that up to 7% or 8% until the market climbs back to a certain level. Then you can decide to dial it back to 6% if you want.
Increasing the amount you save helps you take advantage of market downturns. It's harder to do than you'd think, because it's easier emotionally to put more money to work in the market when share prices are going up and you can get positive feedback from your account statements. Yet the smarter time to do it is when prices are weakening so that you can invest as much as possible when the time is right.
Keep your eyes on the prize
Market downturns often make people forget the reason they're investing in the first place: to have enough money to meet their long-term financial goals. If you get past the panic and stay focused on the long run, it's easier to use strategies like these to improve your chances of a financially secure future.
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