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Last week I wrote about a few things investors should do if they knew a market correction was coming. The preparation for the impending correction was simple: Review your holdings to ensure your portfolio was still properly balanced so that no one stock commands the lion's share of your investable dollars, determine whether your investing thesis was still alive, and mentally prepare yourself for some possible short-term paper loses. Then sit back and let the market do what the market does, because even if the market declines in the short term, it tends to rise ever higher in the long term.
I got a number of reader comments on the article, but one stood out to me. Misterpotatohead wrote, "So how exactly does this strategy differ from any other period in the market cycle?"
Well, let's first look at the market and its cycles. My colleague Dan Caplinger recently published a great piece explaining that when we look at the history of the markets, we typically see three 5% corrections each calendar year, one 10% correction each year, and a 20% correction once every three and a half years.
Since nobody has a crystal ball to magically predict when each of these corrections is going to happen, I think we should approach investing with the assumption that a correction is always about to happen. A simple answer to Misterpotatohead's question, therefore, is that my strategy for how investors should act if they knew a correction was coming doesn't really differ from how investors should act at any other time. We should always be prepared so that we can sell stocks that have a broken investing thesis, pare back our big winners to rebalance our portfolios and spread the risk evenly, and have cash available so that when the markets or an individual stock pulls back, we can, as Warren Buffet says, unload our elephant guns and buy stocks at a discount to their intrinsic value.
Since the beginning of the year, the Dow Jones Industrial Average (DJINDICES: ^DJI ) is up 15.35%, while the S&P 500 (SNPINDEX: ^GSPC ) has risen 14.23%, and over the past five months we haven't yet seen any meaningful pullback. Not even a small 5% correction. The inevitable will happen, though. Stocks will decline in value. Fear will run high. Rational people will act irrationally. Billions of dollars will be lost simply because investors weren't prepared for the future.
Whether you're new to investing or an old pro, a few simple things will help you from adding your hard-earned cash to the billions that will be lost in the coming correction. First, take Morgan Housel's advice and memorize the five things we should all know about investing. In fact, double-memorize the first point. Then once you have a solid foundation and an understanding of how to make money through investing and what to avoid, never change your strategy, never forget the power of compounding interest over time, stick to your guns during the bad times, and prepare during the good times.
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