Are falling markets good?

When markets fall, it's easy to get nervous as an investor. On paper, the value of your investments has dropped. Depending on your situation though, a market drop can be a good thing.

It all depends on your time horizon. If you are looking to take money out of the market in the near term, then falling prices are a bad thing. If you're looking to invest for the long term, then falling markets can be advantageous.

There is a caveat to this though - it's important to distinguish between markets which are in permanent decline vs temporary decline. In the case of the 2008 financial crisis, many companies saw their share prices tumble, even though their underlying business was still strong. It would have been unwise to invest in the newspaper market in 2005, and expect it to only be a temporary decline.

One issue with falling markets is it can rattle investors. If an investment falls by 10%, it can feel painful, and there's the temptation to sell. If you believe it's only a temporary decline, you should ride it out, and wait for the market to recover. Remember - buying in and out of investments often carries associated costs, so you don't want to hop in and out of the market every time it rises or falls a few percentage points.

If you begin to suspect an investment will never recover, it's important to cut your losses quickly. As explained in the irrecoverable losses guide, if your investment portfolio permanently loses 50% of it's value, it can take over a decade to recover. This is why Warren Buffet's first rule of investing is don't lose money. Everyone loses money at some point, but don't lose enough to permanently damage your portfolio.

When a market is falling, and you're sitting on cash, what should you do? Nobody can predict where the bottom will be. Do you put it all in today, or wait? One strategy is to use dollar cost averaging, where you invest a set amount at regular intervals. That way you'll get the average price over time.

Another approach is to have an underlying metric in your mind which you are looking for. If you're able to value a business, and you think the current market value is cheap given its future prospects, then you should buy. For tracker funds, if the opening price is less than the average price I've paid in the past, then I typically buy. That way you're bringing down your average cost. The bigger the difference, the more you put in.

In some ways, falling markets are easier to deal with than rising markets. If you paid £10 for something yesterday, and today it costs £12, what do you do? You're getting a worse deal. In those situation it can be best to look elsewhere. Perhaps it's time to buy some more bonds instead of stocks, or look to other markets. And if there's nowhere good to invest, just hold the cash, and wait for the next opportunity.