With the market dancing around correction territory, many investors have shifted their perspective from “how high can the market go?” to “how far can it fail?” The fear is palpable, and the volatility index that measures such things is certainly projecting that fear will continue.
The market’s drop and spiking volatility raises a very important question: Is it safer to pull your money out of the stock market now? That question is an easy one to ask, but its answer depends a lot more on your overall financial condition than on what the market may do in the near future.
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Why your personal financial condition matters
As the early part of 2022 so brutally reminded us, stocks can go down as well as up. That makes it very dangerous to rely on stocks for money that you need to cover your near-term costs. Because of this, it really only makes sense to have money in stocks that you don’t need to spend in the next five or so years.
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If your personal finances are set up in such a way that you can afford to wait five years before tapping your stocks, then it’s much easier to wait out a market that remains rough for an extended period. If they aren’t, then it gets far harder to persevere through a long bear market. After all, if you urgently need the money, you may not have the option to hold on for better days. In addition, it just gets that much harder to hold on as money you’ll need soon seems to evaporate before your eyes.
This doesn’t mean you need to have five years’ worth of expenses socked away in a savings account or other high-certainty location, unless you rely exclusively on your investments to pay your bills. If you have a job, a pension, Social Security, or some other form of cash flow that covers your costs, you may not need any more cash savings than a standard emergency fund.
If, however, like many people, you are saving to buy a car, a house, a college education, or some other major expense, things get a little trickier. If you have a hard deadline for those purchases within the next five years, that money shouldn’t be in stock. If you can accept the possibility of pushing off those purchases when the market doesn’t cooperate, then it’s up to you to decide whether the potential reward is worth that risk. Just don’t act surprised when the market moves against you and postpones those plans.
If you’ve got the flexibility to wait, then the trade-offs change
On the flip side, for money you no need to spend within the next five years, there’s a case to be made that it might actually be riskier to keep your money out of stock. This is because with inflation running near 8%, your money loses serious purchasing power by sitting in cash or low-return fixed income. Over the long haul stocks have delivered returns at around 9% to 10% annualized. While those returns aren’t guaranteed, they do provide at least a fighting chance of keeping up with even that high inflation.
In addition, some companies might actually do well during inflationary times. Businesses that can either raise their prices or leverage already owned infrastructure instead of having to continuously invest can often profit when inflation is high due to those built-in benefits.
Still, it’s important to remember that even if a company can keep up with — or even outpace — inflation over time, there are no guarantees that its stock will move up, especially in the short term. That is why it is so very important to have a long-term time horizon for any money that you have invested in stocks.
Recognize, too, that there’s value in falling prices
The other key piece of information to keep in mind as the market is falling is that the stock market attempts to price companies based on their future potential. All else equal, paying $10 today for $1 of potential annual earnings for the foreseeable future is a better deal than paying $20 today for the same future earnings stream. As a result, the lower stock prices found during a market crash make the stocks of ultimately successful companies a better value than they were at elevated prices before the crash.
In other words, a falling stock market brings with it the seeds for potentially faster wealth creation in any recovery that may follow it. The key is to recognize which companies have the staying power to make it through any tough times that come along with a falling market. After all, for a company’s falling stock price to ultimately recover, it still has to have a potentially rosy future that investors are willing to pay for.
Still, if you can find those strong companies trading at value prices in a bear market, it can provide a great foundation for a future fortune to reveal itself. It’s not an easy path to wealth, but it is the path that value investors like Warren Buffett have blazed for others to be able to follow.
Get yourself ready now
The key benefit of being able to invest during inflationary times and stay invested even as the market drops is that over the long run, it provides your best chance of protecting your purchasing power. It’s not always easy to get in the position to do so, but once you do, you’ll be glad you did.
Start today by getting a plan in place to get your personal financial condition healthy. Once you’re there, you’ll be in a much better spot to benefit from the market’s long-term potential, even if you have to stomach some extended periods of rough times along the way.
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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.