Stock market corrections are an inevitable part of investing. Since 1932, declines of 10% to 20% (the traditional definition of a correction) have occurred an average of every two years, according to InvesTech Research. The last one was in 2011 (though we came close in 2012). The physics of the stock market haven’t changed: What goes up can’t go up forever. Are we due for a big drop?
Sources: InvesTech Research, Yahoo
Beef up your buying power. While stocks continue to hit record highs, take some profits from your winners and build a cash reserve. You may also want to unload some clunkers. When the market finally sinks, scoop up bargains. “We’re prepared for the emergence of more-meaningful discounts,” says David Perkins, co-manager of Weitz Value fund, which at last report had nearly 30% of its assets in cash.
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Prepare a shopping list. Jot down a list of stocks you’d like to acquire at lower prices. “There are many stocks on my buy-at-the-right-price list,” says Wasatch Funds chairman Sam Stewart. He likes health care and would start to nibble at Walgreens (symbol WBA, $72) if it fell to the high $50s. Scott Klimo, director of research at Saturna Capital, which manages the Amana funds, would use a 10% correction to add to a stake in search engine giant Google (GOOG, $560) and Borg Warner (BWA, $63), a leading maker of turbochargers. (All prices are as of May 30.)
Don’t miss a stealth correction. Broad measures such as Standard & Poor’s 500-stock index have been marching to new highs, but a closer look at the market shows that some sectors have already taken big hits and are starting to recover. Two examples: Internet services and biotech stocks. “Now is not a bad time to buy the stocks that got beaten up,” says Ed Yardeni, an economist and market strategist.
Turn off the TV. If a decline starts to snowball, you’ll hear about it—over and over. “Don’t become your portfolio’s worst enemy by allowing yourself to get caught up in the negative hysteria,” says Sam Stovall, chief stock strategist at S&P Capital IQ. Instead, remind yourself that the market has experienced 20 drops of 10% to 20% since World War II (plus 13 bear-market tumbles of at least 20%). Even so, large-company stocks have returned 11.1% annualized since the war’s end.
Have a strategy. You’ve probably heard of dollar-cost averaging, a strategy of investing a set amount in the market at periodic intervals. Consider a correction-market twist: Invest periodically, but use decline thresholds instead of time intervals to determine when. For example, you might put a set amount into stock funds in your 401(k) after every 5% dip.
Anticipate better days. The effects of corrections don’t last long. After a drop of 10% to 20%, it typically takes just four months to break even, says Stovall.