Stock Market Corrections 101

Bonds, Commodities, Investing & Retiring, Stocks

The term “market correction” is unsettling to most investors, but it really should not be. If you take the longer view of investing and resist overreacting, you may be able to capitalize on the correction and make long-term lemonade out of short-term lemons.

A correction is generally defined as a relatively short-term loss of 10% or more in a given stock, bond, commodity or index to adjust for overvaluation. There is no single definition of what “relatively short” means. The correction could be referring to an individual stock, but when we talk of stock market correction, we are usually referring to an index such as the Dow or the S&P 500.

The term “correction” is insightful because some sort of imbalance is always being corrected. Bull markets can leave investors scrambling to not be left behind, and potentially paying more for a stock than is necessary. Emotion can trump reason. Prices are therefore driven up beyond the intrinsic value of the underlying companies.

Eventually, this elevated price becomes unsustainable, and the market corrects itself through investor’s unwillingness to pay the price and stockholders cashing in for the short term. You can play corrections to your advantage by following some simple rules.

  • Avoid Herd Mentality – Herd mentality is what causes overvaluation and panics in the first place, and herd mentality will not get you out of one, either.

    Taking the long view will help you resist the emotional urges to buy as the market goes up and to sell as it crashes. Yes, you will occasionally miss a surging stock, and you will lose money in the short term during a correction. Your focus must be on minimizing the damage during the correction and looking for opportunities as the correction bottoms out.

    This can be difficult to do, and you can get burned by a correction that turns into a full-blown bear market. In that case, you can minimize the damage by keeping your portfolio relatively diverse – which you should be doing anyway.

  • Evaluate Individual Stocks – Fundamentally sound stocks can be caught up in panic selling and will be eventually be selling at a discount below their intrinsic value. If you believe they have greater underlying value than their market price suggests, do not necessarily jettison them as they fall. To mitigate risk, you can buy the same issues as their prices fall during the correction, which lowers your average share price for the stock.

    Of course value does not necessarily mean a low stock price. A $10 stock may be a worse bet than a $100 stock if the $100 stock appears undervalued. To find such stocks, look for below average price-to-book or price-to earnings ratios, and/or those with high dividend yields.

  • Check Stock History and Recent News – Is a normally stable stock becoming unusually volatile? Perhaps there is unusual excitement over a new product offering, or concerns about a pending lawsuit. Is this enthusiasm warranted by the facts? Separate emotional reasons for volatility from logical ones, and you will generally come out ahead.

At the end of the day, market corrections give you the opportunity to practice the often-quoted advice of “buy low, and sell high”. The trick is in understanding when high is high enough and low is low enough to act. With fundamental analysis and avoidance of following the herd, you can use stock market volatility to your long-term advantage. That said, it can be dangerous for private investors to believe they can “time the market” better than full-time institutional investors. So the buyer should always beware.

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