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Fool On The Hill

Tuesday, June 1, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Yippee! Prices are Falling

Dour hosts on CNBC and the major news networks are lamenting the current market weakness. If you didn't hear, although the Dow Jones Industrial Average was up 0.35% today, the Standard and Poor's 500 dipped 0.58%. Since peaking in mid-May, these averages have fallen 5% and 6%, respectively. Is your investment safe? How should you react? Everyone is willing to throw in their two cents, and so will I.

As the title to this article suggests, I am not disappointed to see a drop in the stock market. In fact, I relish it. As long as the underlying fundamentals of a business are unchanged, these price declines let me invest in companies I want to own at lower prices. Assuming the end price 10, 20, or 30 years hence is not affected by whatever causes a stock to dip, I will ultimately get a higher return on my investment. Whenever the stock market drops, I think of myself as receiving a "bonus" sale from those selling.

I am in the savings phase of my life, tucking away a little money each and every month. Because most of my fresh investing money flows into a 401(k), which doesn't allow me to pick individual stocks, I am gradually picking up more and more exposure to the S&P 500 via an index fund. As this money makes its way into the market, I certainly prefer picking up shares at lower, rather than higher valuations.

I have no idea exactly where the S&P 500 will be in 30 years when I retire, but my hunch is that it doesn't really depend on today's level. While the ultimate value of the index doesn't hinge on today's value, it does impact the number of shares in the fund that I can purchase.

Let's assume that I invest $100 a month into an S&P 500 fund. Right now, if the fund trades at 1/100 of the value of the index, its price would be $12.94 per share. My monthly investment would purchase 7.8 shares. Let's now assume that the fund price increased to $14.00 a share next month. With a $100 investment, I would pick up an additional 7.2 fund shares. The following month, the Wise men of Wall Street put out a warning stating that stocks are poised to decline because of a slowdown caused by Y2K issues. The market tremors and the index fund falls to $10.50 per share. My $100 investment acquires 9.5 shares.

Now let's fast-forward 30 years. Only old-timers will even know what the Y2K issue was as the S&P 500 flirts with the 13,000 level (for those keeping track, that's a fairly conservative 8% compound annual return). Each share of the index fund would be trading for about $130 (yes, it may have split, but we won't worry about that since a split does nothing to change the underlying value of our holding). What kind of returns will we have obtained?



         Initial    Shares    Ending     Total

       Investment  Acquired    Value    Return

Month 1     $100      7.8     $1,014      914%

Month 2     $100      7.2       $936      836%

Month 3     $100      9.5     $1,235    1,135%

The return during Month 3, when the index was temporarily knocked down, ended up ended up being the highest. In fact, my portfolio will be worth at least an additional $300 thanks to the price decline in '99. I say "at least" $300 because my example ignored the reinvestment of dividends, which would further boost the ultimate return.

Of course, if you need your money now or in the near future, negative movements in stock prices are nerve-wracking. That's why we recommend putting only money that you don't need for at least five years into the stock market. How do we come up with a time frame of five years? According to Ibbotson Associates, returns for large company stocks have been positive in 62 out of the 69 possible five-year, rolling timeframes since 1926, a 90% success rate. While history isn't necessarily indicative of future results, these odds are pretty favorable for investors.

If you're continuing to invest in the market on a regular basis, temporary bumps in the road are actually excellent opportunities. While your current account value will be smaller, your culminating account value years from now will be much higher so long as you continue investing throughout the downturn. When you think about this column in simple words, it's pretty easy to understand. Buying low, when you are confident about the future, is a smart strategy.

In the spirit of uncompromising honesty, a core value here at The Motley Fool, I must tack on a slight addendum to this article. I unFoolishly invested some money into the stock market that I'll need for a major purchase in the next six months. At the time of the move, I noticed the surging stock market and felt that market momentum and my knowledge of the companies would lead to a near-term gain. Although the stocks I picked haven't been hammered by the recent downturn, the drop did cause my heart to flutter much more than normal. To reduce this anxiety, I have taken almost all of the money I'll need later this year off the table and put it in a money market account. The 4%+ annual return may sound uninspiring, but the comfortable night's sleep is well worth it. The stock market is definitely not the place for money you'll need to use in the short-term.