The stock market has been on a downward trajectory over the past few weeks, mainly due to fears and uncertainty surrounding a potential trade war.
As I write this, the Dow Jones Industrial Average is extremely close to entering “correction” levels once again, which is defined as a 10% drop from recent highs.
With that in mind, here are three key principles to remember when the market drops.
Corrections (and even crashes) are a normal part of the stock market
If you aren’t comfortable with fairly frequent stock market corrections and the occasional market crash, you probably shouldn’t be invested in stocks. Period.
Market corrections and crashes will happen. It’s not a question of if they’ll happen — the only uncertain parts are when they’ll occur, what will cause them, and just how bad they’ll be.
As Warren Buffett has said: “The years ahead will occasionally deliver major market declines — even panics — that will affect virtually all stocks. No one can tell you when these traumas will occur.”
If the stock market drops by 10% or more, don’t be too worried, despite what commentators on TV might say. As my colleague Sean Williams pointed out earlier this year, we’ve had 29 stock market corrections over the past 50 years alone. Seven of these resulted in declines of 20% or more, and five produced drops greater than 30%.
On a related note, it’s important to focus on percentage declines rather than the actual number of points the Dow or S&P 500 are down. When the Dow was bottoming at less than 7,000 in March 2009, a 100-point drop meant a decline of 1.4%, which is quite a big move. Today, a 100-point drop represents a move of just 0.4%. In short, the Dow, in particular, has gotten so large numberswise that moves often sound worse than they actually are.
Corrections are buying opportunities, not selling opportunities
The absolute worst thing you can do in a correction is to unload your stock investments “before they go down more.” Doing so is the exact opposite of what you’re supposed to be doing as an investor — buying low and selling high.
Instead, the right way to look at a correction is like you would approach a big sale at your favorite clothing store. You may buy some clothing at regular intervals over time with little regard to the prices. After all, sometimes you just need a shirt or some new socks. However, if you discovered that everything in the store was suddenly marked down by 30%, what would you do? Chances are, you’d buy more clothes than you normally would, knowing that the discount wouldn’t last forever.
Smart long-term investors apply the same logic to market corrections. It’s generally a bad idea to try to time the market, but investing a little bit at regular time intervals is always a good idea. However, when prices fall, especially in solid companies you love, the market is going on sale. Take advantage.
This is especially true if the correction or crash is sector-driven or if there’s a specific fear that affects a certain group of stocks. As a personal example, I’m thinking of adding more to my Caterpillar investment, as it’s a great company that has fallen sharply because of what a trade war with China could potentially do to the company’s profit. I think of this as if long-term winning company Caterpillar is on sale because of a temporary headwind. Could a trade war with China hurt Caterpillar’s profits? Absolutely. Will it hurt the company’s profits forever? Probably not.
Long term, stocks almost certainly will continue to go up
The only group of investors who need to worry about stock market corrections are short-term traders. If you continually move in and out of stock positions, especially if you use leverage (margin) to do it, a correction is something to fear.
However, long-term investors should embrace corrections, not fear them. Over 12-month periods, stocks (as an overall asset class) outperform risk-free U.S. Treasury bills 70% of the time. Over 10-year periods, that figure jumps to 84%. Over 20-year periods? Your money is better off in stocks 100% of the time over any 20-year period since 1926 — and this period includes the Great Depression, Black Monday in 1987, the dot-com bust, and the Financial Crisis.
In a nutshell, while nobody has a crystal ball, history is pretty clear on this point. Over long periods of time, there’s only one direction in which stocks go — up.
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Source: The Motley Fool