The Dos and Don’ts During a Stock Market Correction

Last week, the week of February 24, 2020, the stock market nosedived due to concerns about the novel coronavirus (COVID-19) and its impact on the global economy.

The Dow was down 12.4%, and the S&P dropped 11.5%.

If those numbers seem arbitrary, consider this analogy:

You know that feeling you get when riding Space Mountain in Disney World? When every steep drop makes your blood pressure rise because the tracks ahead of you are invisible, and you have zero clues when the coaster is horizontal again?

Last week’s stock market was like that, only more dizzying and vomit-inducing.

Yes, it was a market correction.

A stock market correction occurs when stock prices collectively drop at least 10% from their most recent peak.

Even though corrections are a standard feature of the stock market, their negative effects aren’t any easier to stomach.

When you have money invested in the stock market, and 10% of it evaporates in a week, you’re right to be annoyed and even fearful that more of your money could leave without saying goodbye.

But market corrections aren’t something to be afraid of. I would even argue that they present promising opportunities to make bank.

Here’s what you should (and shouldn’t) do during a stock market correction:

DON’T Panic Sell

For most long-term investors (people who are not looking to cash out their investments within the next 10 years or so), the best thing you can do during a correction is to do nothing at all.

That’s way easier said than done, I know.

It’s downright scary not knowing if and when the meltdown will come to an end.

As you watch your stock portfolio shrink like a cotton T-shirt tumbling around in the washer, your natural inclination is to DO SOMETHING to fix it.

When people get into that emotional state, they start to rationalize offloading their positions to “preserve” the value of their portfolios.

But selling is the worst thing you can do in this scenario.

The market will inevitably recover, just like it had after every single correction in the history of the stock market.

That’s right. If you wait around patiently, the problem will fix itself.

Take a look at this handy graph below that illustrates the number of years between major dips and subsequent recoveries.

Source: Four Pillar Freedom

The situation isn’t nearly as dire as it is being sensationalized. In most cases, it only took a single year for the S&P 500 to reach its previous all-time high.

In time, your investments will be restored to their former glory, and any unpleasantness caused by the correction will fade from memory.

But if you succumb to the pressure and sell during a correction, you’re cementing the otherwise temporary loss. Your action reflects the prediction that the market will fall from now until eternity, which you know can’t be true.

If I could throw out another analogy, it would be this:

Your money isn’t lost forever during a correction. It simply went away on an extended school trip abroad, and will return at the end of the semester with souvenirs (can’t wait to get my hands on yet another picture frame covered with seashells!).

Selling during a correction would be like filing paperwork to give up custodial rights. And I don’t have to tell you what a terrible move that would be.

DO Ignore Stock Market News 

Living under a rock is neither cool nor easy to execute when clickbait headlines are vying for your attention.

But when market uncertainties dominate the news cycle like we’re experiencing right now, there’s really not much to gain from following the ups and downs of the market.

Wild market swings are not for the faint of heart, especially those with a big chunk of their net worth tied up in equities.

Reading the Business section of newspapers in times of stock market turbulence is like checking out an ex’s Instagram five months after you broke up – nothing good will come out of it.

At best, you remain stoic about the whole thing. But you could also freak out and send a bunch of drunk texts at 3AM to your former lover, or worse, overreact based on a “hot stock tip.”

Let’s just say we don’t make the greatest decisions when our emotions are behind the wheel. So it’s best to completely tune out stock market news for a while, and not let market instabilities get under your skin.

Unlike most aspects of life, burying your head in the sand and ignoring the gloom, boom, and doom is the correct approach here.

DO Keep Investing In Quality Companies

Market downturn or not, investing in quality blue-chip companies never goes out of style.

(The sentence rhymes, so you know it must be true!)

Truly great companies – companies of the same caliber as Coca-Cola, Procter & Gamble, and 3M – don’t get permanently knocked down by mere market downturns. They have likely survived quite a few recessions and even emerged stronger on the other side.

So that means you, as an investor, should focus on buying and holding stocks of great businesses over long periods of time.

Trust me, if your stock portfolio contains nothing but quality stocks, bought at fair (or better) prices, you sleep better at night, and you will have little to anguish over the next time a market crash inevitably rolls around.

DO Stay Diversified

Diversification reduces risk.

In the extreme case of a single stock portfolio (ex: you only own Tesla stocks), even the tiniest dose of negative news coverage related to this company (ex: Elon Musk smokes weed on Joe Rogan’s podcast) could affect your entire investment.

But if your investments span different financial instruments (ex: stocks, bonds, real estate), industries (ex: energy, health care, financials), geographical regions, and so on, you’re less vulnerable to the perils of any single company.

The easiest way to diversify is to invest in index mutual funds and/or ETFs. If you aren’t sure where to start, check out Canadian Couch Potato’s model portfolios.

DO Keep An Eye Out On Your Money

The stock market going up and down like a toddler’s yo-yo has a side benefit of putting day-to-day money management into sharper focus.

There is no better time than now to beef up your emergency fund, cut back unnecessary expenses and put yourself in the best financial shape possible.

If the market swings are any indication, tough economic times might be ahead. Maintaining your emergency fund of 6 to 9 months’ worth of living expenses is more important than ever. Not only will it lower your day-to-day stress level, but you’ll also be relieved to have thousands of dollars on hand to offset the unpleasant surprises life might be throwing your way. 

In terms of spending, make sure that your spending choices still closely align with your values.

Make a list of your life priorities, and compare it to your actual spending history.

Is the bulk of your money spent on things that are the most important to you?

Let’s say you have a fitness goal, but find yourself charging $400 a month on credit cards for take-out meals, then you know your priorities and actual spending are out of whack.

Take this opportunity to reflect and potentially make lifestyle changes that will pay happiness dividends later on.

MAYBE Buy The Dip

As we’ve seen last week, when the market plummeted, stocks were trading far below fair value. The best time to go shopping for stocks is when they’re on sale.

Yes, the common adage is that time in the market is more important than timing the market.

But when a golden investment opportunity presents itself, how can you resist?

I certainly can’t, and I know many other investors could relate to the insatiable desire to scoop up stocks at attractive valuations.

But this move is not suitable for everyone.

Who it is for: seasoned investors who know what they’re doing, have a moderate to high-risk tolerance, and the bankroll to fall back on (a fully-funded emergency fund and at least $10,000 to invest).

Who it is not for: everyone else.

It’s a high-risk, high-reward type of ordeal.

To capitalize on the potential to make a lot of money when the market rebounds, you must be willing to shoulder the short-term risks and go against the grain ― buying when most investors are bearish.

It is entirely possible to lose more money as the market continues to go down. You need to be mentally and financially prepared for that possibility. 

If that sounds good to you, and you just can’t wait to get your hands on fantastic stock deals during a mini-recession, read on.

First, find out the root cause of the correction, as this would give you clues on which way the stock market is heading.

Is it caused by a general downturn of the economy, political unrest, or a worldwide pandemic like the coronavirus?

I would argue that as long as the economy is in decent shape (positive GDP growth), and company fundamentals remain strong (revenue is rising compared to the previous quarter), it’s likely that the market could bounce back fairly quickly once the panic dies down. In that case, it’s OK to jump in when the Dow plunges.

Otherwise, stay cautious and vigilant. You don’t want to end up catching falling knives. It might be wise to sit on the sidelines for a while, see how the trend unfolds and load up on cheap stocks at even better valuation later.

In any case, we do not have perfect information to accurately predict what happens next, so my preferred course of action is to be prepared for both outcomes – a quick recovery, or a further plunge.

Next up, decide how much you want to invest during the current market correction.

My personal rule of thumb is to invest as much as possible to avoid any regrets in the future, and as little as possible to keep a sizable amount of cash on hand to rebuy the dip if the market continues to free fall. This usually works out to be 20% to 30% of my cash reserve (cash that sits idly in an investment account waiting to be deployed).

I know that if I wait too long for the market to bottom out and miss the window of opportunity, I would be immensely disappointed.

The Dow is up 5.09% today. I’ll take it! Who else bought on the dip late last week?

— Flora | Casual Money Talk (@casualmoneytalk) March 2, 2020

This is why I bought 18 stocks, 2 REITs, and 1 ETF last Friday, which just turned out to be the day the Dow fell to its recent bottom.

As you can see, I have gone a bit nuts buying more than $26,000 (a mix of Canadian and US dollars) worth of equities in a single day.

I invested just enough so that I was perfectly fine whichever way the market would go. It was as much as an investment in stocks as a ransom for my perpetual peace of mind.

It just so happened that last week’s market correction was immediately followed by an aggressive 5.09% single-day rally in the Dow, so it looks like I netted a decent profit for the time being. But I honestly would feel equally comfortable if the market indices continued to head south.

With coronavirus’ rising death toll and uncertainties surrounding the upcoming American presidential election, it’s anyone’s guess whether the current correction will turn into a full-blown recession later this year.

In any case, I’m ready for anything. Bring it on, stock market!

How are you preparing for the market turbulence? Are you feeling optimistic about the immediate future of the global economy?