Investing During a Correction

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Volatility has returned to the markets and a bearish mentality has begun to creep into many investors minds. Over the past week, the S&P 500 has dropped more than 3.5% while the NASDAQ has fallen over 4% in the same time period. While it’s too far early to call the movement a bearish reversal, it does appear to be a correction.

Corrections are a normal part of market dynamics. They typically result in a downturn of about 10%, helping to alleviate some of the overvaluations and allowing the market to cool down before resuming its upward trend. Tracking the performance of the broader averages over the past two months reveals a drop of about 10% for the S&P 500. The next few weeks should tell the story as to whether the dip is just a correction, or the start of a larger negative trend.

Portfolio protection doesn’t mean hiding your money away

Fear can be a powerful motivator, but often leads to rash decisions. In the stock market, this kind of panicked action can mean selling holdings for a loss and missing out on potential opportunities. The only real guarantee during a downturn is that any stocks sold at a loss means realizing an actual loss in your portfolio. As long as you still own the stock, any gains or losses don’t mean anything until you make a closing trade.

Some investors choose to get out of the market altogether during the first stages of a correction. They sell most or all of their holdings and park that money in a safe place such as a savings account. It’s hard to argue against it when you see broad drops in the stock market, but there’s a better way to handle the volatility.

Historically, investing at a market peak right before a downturn still results in a net profit when you consider long-term investing of a decade or more. If you had purchased an index fund for the S&P 500 in the summer of 2008 ahead of the sub-prime crisis and held it, you would still have a gain of nearly 70%.

Investors shouldn’t be discouraged from keeping some money on the sidelines in a liquid savings or money market account however. Even in bull markets, keeping a little money freed up on the side means having the ability to make quick purchases when opportunities present themselves.

When it comes to the economy as a whole, there’s no such thing as a broad trend with perfect correlation. In other words, there is always a bull market and bear market happening somewhere. Investors should remember that even during corrections and bear markets, there’s a sector of the economy that will benefit and post above-average gains.

Final thoughts

It seems counter-intuitive, but buying during a corrective phase when everyone is selling can mean getting fundamentally strong stocks at huge discounts. The key takeaway is the phrase “fundamentally strong.” Negative selling pressure can bleed over into broader market sectors with stock prices dropping for reasons unrelated to that company’s performance. For value investors, down markets can be the perfect environment for bargain hunting.