The stock market is undergoing a correction, and it is about time. We haven’t seen a meaningful move down in stocks since April. Furthermore, we haven’t seen a 10 percent plus correction in stocks for over two years, and this is highly unusual given the normal volatility in the stock market.
With this in mind, a correction is long overdue. Unfortunately, the fact that we haven’t seen a correction in a while means that there is a heightened risk that it will be more severe than one would expect. Investors should keep in mind that there are a lot of potential catalysts that can send the stock market lower such as the end of quantitative easing — which is approaching in October — and rising geopolitical tension in Eastern Europe. Consequently, investors should be prepared for a correction, and further, they should be prepared for the possibility that it is steeper than any we have seen in the past couple of years.
Again, this is a normal occurrence in the stock market, although recent stock market euphoria has done a good job of blinding investors to this reality. But just because corrections in the stock market are normal doesn’t make them any less painful. So how do you bring your emotions under control and use the correction to your advantage rather than panicking and selling near the bottom?
Here are some tips.
First, go through your portfolio and re-evaluate your stocks. Companies change, and so do your opinions of them. With each stock, ask yourself why you bought it, if you still believe in the thesis, and whether the current valuation supports still holding the shares. You should also evaluate your portfolio as a whole. Keep in mind that as stock prices fluctuate, your portfolio will be skewed towards sectors that are outperforming. A correction could be a good opportunity to redeploy funds from these outperforming sectors into underperforming sectors — especially if you still believe in the fundamental case for owning the underperforming sectors.
Second, if you have a lot of profits in a company, you should sell some even if you think the stock has more upside. Stock market corrections hit nearly every stock with very few exceptions, and even if you like the stock of a company chances are it is going to fall.
Third, you should sell any stock that appears to be “rolling over.” Take a look at the stock’s chart and see if it it shows signs of a double top, or if it hasn’t made a new high in many months. These can be signs that investors are getting out of the name, and these stocks could be big losers if the market continues to fall.
Fourth, get ready to buy. Specifically, you should make a list of stocks you want to own. After you put a stock on the list, figure out the price you are willing to pay for it. Remember that during a correction stocks tend to go from being overvalued to being undervalued. So if you think a stock is worth, say, $75/share, you might want to be stingy and pay only $68/share. Put a limit order in the market and leave it alone. If you wait for the market to actually reach that level you risk panicking, especially if the stock market is falling on a lousy piece of economic news or a negative geopolitical development.
If you do these things in a level-headed fashion, you will be able to make beneficial changes to your portfolio. You may have to take some losses, and you may sell a stock or two that you really like or that ends up rising higher, but in the long run you will be better positioned for when the market rises again.