This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Nobody likes seeing their portfolio's value drop. That defeats the purpose of investing. Unfortunately, this has been the case for many investors in 2022, as the stock market has been in a bear market since June of this year.
A bear market happens when one of the major indexes (usually the S&P 500) falls by 20% or more from recent highs. And that's exactly what we've experienced. Since the beginning of 2022, the S&P 500 is down over 24%, the Nasdaq Composite Index is down over 32%, and the Dow Jones Industrial Average is down close to 20% (as of Oct. 8). So, to put it lightly, it's been a rough year.
However, it isn't all gray clouds for investors. In fact, bear markets are actually a necessary evil. That may sound backwards, but hear me out.
What controls stock prices?
In the short run, stock prices are a reflection of how investors feel. If a company reports good earnings and its stock price goes up, it's not because of the earnings themselves; it's because of how investors feel and react to the earnings. That's why there are cases of companies reporting good earnings and their stock price dropping, and vice versa.
This is important because to really understand why bear markets are a necessary evil, you have to understand investor sentiment.
It comes down to risk vs. reward
The most fundamental principle in investing is that risk is tied to potential reward. The riskier an investment, the more an investor expects to be able to make. Investors don't expect to receive large returns from Treasury bills, for example, because they're as close to a risk-free investment as there is. However, stocks are one of the riskier investments, so investors expect the chance to make huge returns.
If the stock market never experienced bear markets and prices only went up, there would essentially be no risk. And the less perceived risk there is, the more investors are willing to pay for stocks because they don't feel like they'll lose money either way -- which sets off a chain reaction. Stock prices keep rising because investors are willing to pay more in pursuit of big returns. price-to-earnings (P/E) ratio keep going up, and potential long-term future returns fall as a result. Rinse and repeat.
Since investors know that stock prices can drop and bear markets can happen, they "price" stocks with this risk in mind. This is a good thing because it keeps expected returns high. For long-term investors to make sizable returns over time, they almost need bear markets to happen occasionally.
Use bear markets to your advantage
Instead of viewing bear markets as negative, start viewing them as an opportunity. Specifically, they can be a chance to lower your cost basis, or the average price you've paid per share of a stock.
For example, if you used $1,200 to buy 10 shares, your cost basis would be $120 per share. If the stock price then fell and you bought 10 more shares for just $1,000, your new overall cost basis would be $110 per share:
- 10 shares * $120 = $1,200
- 10 shares * $100 = $1,000
- $2,200/20 shares = $110 per share
Your cost basis determines how much you profit (or lose) when you sell shares. Two investors can sell the same number of shares for the same price, but the one with the lower cost basis will profit more. As stock prices fall during bear markets, this may be a chance to get stocks for lower than your cost basis and set yourself up for greater profits in the future.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
