The Maths of Buying When Markets are Down

Falling markets are largely seen as a challenge for investors – and as I write markets are down a little more than 12 per cent from their highs, providing a challenge in real time.

This current downturn comes on the back of sharp downturns of more than 40 per cent during the GFC, or Global Financial Crisis, and again at the start of COVID-19, where the Australian market fell more than 40 per cent from above 7,100 points in Feb 2020 to around 4,800 points by the end of March 2020.

Indeed, it is interesting to note that at the start of the GFC in October 2007, the ASX200 was at 6,750 points – exactly where it is as I write, 15 years later to the month. Of course, over this time there has been a flow of dividends and franking credits to investors. Still, it provides an interesting counterpoint to the managed fund credo that often suggests five to seven years is a long enough timeframe to have a positive experience investing in shares. The current experience of 15 years with no capital growth underlines that there can be extended periods of time of below average investment returns.

Buying When Markets are Down

Let consider the maths of buying when sharemarkets are down by looking at a quick scenario.

Olive, a sharemarket investor, buys $10,000 worth of XYZ shares at $10 per share.

XYZ shares then halve in value.

Olive buys a further $10,000 worth of XYZ shares at $5 per share.

Now a question, what is the average cost of the XYZ shares that Olive now owns?

My suspicion is that most people will say that it is $7.50 per share, the average of the $10.00 and $5.00 purchase prices.

In fact, it is $6.67 per share. This is because when Olive bought the first $10,000 worth at $10 per share, she ended up with 1,000 shares. Then, in buying a further $10,000 worth at $5 per share she buys twice as many shares, 2,000 shares, at the lower price.

In total, Olive has spent $20,000 to buy 3,000 shares which means an average price of $6.67 per share.

Holding Their Nerve

Let us add a second mathematical observation and consider what has happened in reality with sharemarket returns following market downturns.

An important reality is that when there is a sharp fall in sharemarket prices, this presents a significant opportunity – including the ability to buy more shares as per the scenario above. Let’s look at the rewards investors have received for holding their nerve and investing when markets were low during significant market falls:

• 1987 Sharemarket Crash to now: 10.2 per cent per annum or $10,000 invested then turning into $310,000 now (based on total returns – income and growth)
• 2009 GFC downturn to now: 10.5 per cent per annum or $10,000 invested then turning into $37,000 now (based on total returns – income and growth)
• 2020 COVID-19 downturn to now (from the March 2020 market low): 40 per cent growth plus 11.2 per cent dividends or $10,000 invested then turning into $15,200 (based on total returns – income and growth)

The Strategy

Both elements of maths that we have considered supports the idea that buying shares when markets are down is an activity that is well-rewarded. The famous Warren Buffett quote encouraging us to be “fearful when others are greedy, and greedy when others are fearful” is easy in theory, but much harder in practice.

The two elements of maths that we have touched on, the maths of making additional investments when markets are down and the maths of future returns after downturns, might help us hold our nerve a little while others are fearful.

In a practical sense there are two key approaches that people might utilise in buying extra assets when markets are down — continuing regular investments or using a strategic cash allocation to take advantage of markets falls.

The first is the use of regular investments such as ongoing superannuation contributions. The reminder that buying when markets are down creates opportunities might be useful in holding our nerve with our regular investments given they are likely to be effective in the long run. Regular investments also have the advantage that they are often relatively small sums of money compared to the overall value of the portfolio and it is easier to be brave with smaller sums of money.

That said, there is a path to investment success even for people who become more nervous when markets are down. Changing ongoing investments from the normal option, say, a balanced contribution that might be 60 per cent growth assets to a defensive option that might be 40 per cent growth assets, still sees regular investments into some growth assets that are purchased with lower prices.

The second approach is the use of a strategic cash allocation to buy assets while they are down. Some people might hold an additional 5 per cent to 10 per cent of their portfolio in cash beyond their core cash allocation to be an opportunistic buyer during downturns. The use of this cash in 1987, 2009 and 2020 would have been well rewarded.

Conclusion

The fundamental nature of sharemarket investing is that you are investing in a volatile asset class. This is not an easy exercise. Keeping in mind the two mathematical pillars of support for investing when markets are down, the power of buying more assets at lower prices and the history of returns from investing after markets have fallen, might help us see the value of sticking with our investment strategy, and even accumulating assets, during these challenging times.