Catching Falling Knives? Smart Strategies for Buying Stocks in a Downturn.

As stock prices decline, you may feel as if you're at the world's biggest sale. Suddenly, stocks that seemed expensive weeks ago are trading at bargain valuations. You may be tempted to jump in and catch that falling knife, hoping you're buying at the best price. Of course, it's nearly impossible to time the market, so you're unlikely to buy a stock at its lowest and sell at its highest.

If you're a short-term investor, this could be a problem. In this case, it's risky to buy a stock as it's dropping because it may take a while for it to recover and go on to gain. Meanwhile, if you aim to sell in a few days or weeks, you may have caught the knife by the blade and find yourself recording a loss.

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However, if you're a long-term investor, the picture looks much different. You can buy stocks during a downturn because, by holding on for five years or more, you're giving those companies time to recover and grow and the share price an opportunity to reflect that progress. Now, let's check out some smart strategies for buying stocks during a downturn.

Image source: Getty Images.

1. Invest with confidence

Although on the one hand, those bargain stock prices may have caught your eye, you might still worry about investing when the general environment seems uncertain. What if current problems persist? What if stocks fall even further? Those questions could be running through your mind.

This is when it's a good time to consider what history has to say. My colleague Adam Levy recently wrote about what has generally happened after stocks fall into a correction, and this offers us reason to invest with confidence during these periods. The S&P 500 index (SNPINDEX: ^GSPC) has slid into the correction zone 15 times since 2008, Adam wrote, citing Dow Jones Market Data, and in all but two of those times, the index was higher a year later.

This means that corrections offer us a fantastic buying opportunity, one that will generally start delivering in the not-too-distant future. It doesn't matter when you buy during the correction; even if stocks continue to decline, your gain may still be significant once shares recover and travel through stronger market environments. So, the message here is not to hesitate to buy stocks during a correction. History shows that it's been a great bet for long-term investors.

Finally, it's also a smart idea to look at buyback activity in the recent past. In the fourth quarter of last year, for example, S&P 500 buybacks increased by more than 7% to about $243 billion, suggesting companies are confident about the future. So, growth in share repurchases supports the idea of investing regardless of what the market is doing at the moment.

2. Focus on value players before a market downturn

It's impossible to know when the market will enter its next negative phase, but we know it will occur at some point. Markets go through bull and bear markets, as well as many other periods of gains and declines, from rallies to market downturns. Some are short, and some are long. But the good news is that difficult periods don't last forever, and certain types of stocks can help you weather the storm.

Generally, the sort of stock that will help your portfolio during a downturn is a value stock. These stocks are in well-established industries, such as energy, healthcare, or financials, and they generate a considerable amount of cash and pay dividends. They are strong, steady, and reliable, and that's why they tend to outperform during tough times. And, of course, investors are especially appreciative of their dividend payments when markets are down.

The MSCI World Value Index climbed 6.1% in 2022, a down year for the overall market, outperforming the MSCI World Growth Index by more than 26%, according to a report by Quilter Investors.

All this means that when markets are rallying and growth stocks are soaring, stock up on value stocks that may support your portfolio during the next tough period.

Image source: Getty Images.

3. Consider lump-sum investing and cost averaging

If you have a certain amount of money to invest, you could deploy it all at once in a lump sum or use cost averaging, which involves investing the same amount of money in a particular asset on a regular schedule for a set period. So, for example, in lump-sum investing, you might invest $1,000 right now in Nvidia. In cost averaging, you might invest $100 in Nvidia every Monday for 10 weeks.

Which strategy will produce the best return? A study by Vanguard shows that lump-sum investing beats cost averaging 68% of the time. That said, the study also showed that in the worst market environments, lump-sum investing resulted in bigger losses.

So, which option should you choose? It depends on your relationship with risk. If you're a very cautious investor, you might try cost averaging, at least with certain investments, while aggressive investors may opt for deploying a lump sum right away.

In either case, though, investing is a better idea than just holding onto cash. The Vanguard study also found that both techniques outperformed cash at least 69% of the time. This means that, even in the most difficult of environments, if you're willing to hold on for the long term, you're better off investing than staying out of the market.

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Adria Cimino has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.