The Smart Way to Invest During a Stock Market Correction

The best time to invest in stocks is also the hardest time to invest in stocks: during a stock market correction. If you let fear dictate your decisions, you'll look back in the future and wish you hadn't. But if you approach the task calmly and rationally, you'll benefit handsomely.

My own approach to investing during a stock market correction includes three steps: identifying quality stocks, averaging into the positions, and then holding them until the market inevitably rebounds. I'm confident enough in the strategy that I recommend it to my friends and family.

Image source: Getty Images.

1. Identifying quality stocks
Quality stocks are easy to identify. These are big, stable, and generally older companies with well-known and durable competitive advantages. They're companies that you've heard of -- ones that produce the products that satisfy our daily needs or that help in some way to push society forward.

It's important to keep in mind that a stock market correction can, and not infrequently does, evolve into an economic recession. This is why size matters. All else equal, a company with more resources and credit at its disposal has a better chance of surviving corrections and recessions than a company with fewer resources.

Size can also reflect on a company's age, which is another factor that investors should consider when picking stocks during a stock market correction. Older companies by definition have survived more corrections and recessions than younger companies. Their leaders assume that a downturn is around the next corner, and they tend to prepare accordingly for that.

"You don't run a business hoping that you don't have a recession," explains Jamie Dimon, the CEO of JPMorgan Chase (JPM -0.40%).

We think [the business] should be prepared for adverse times. In fact, we think if you're strong in adverse times that that puts you in the position where you actually can do more interesting things, either hire people or buy other companies that are having a tough time.

Run your business knowing it might be sunny, it might be stormy, or in fact it might be a hurricane. And be honest about how bad a hurricane might be.

That's how great executives think. And the chances that you'll get an executive who is tried and true like JPMorgan Chase's Dimon is much better if you invest in large, well-established companies founded decades ago. Here are 10 that make the cut in my book:

Market cap data from Yahoo! Finance.

2. Averaging into positions
The biggest mistake that I've made in past stock market corrections is to spend all of my available capital too early in the downturn. I see that stocks have dropped by 15% (or whatever) and decide that they must have reached the bottom. I then pile into the market only to watch stocks fall another 10%.

This is discouraging. It's also unnecessary given that there's a better way to buy stocks during a correction.

Let's say that you have $10,000 worth of cash in your IRA. After you feel that stocks have dropped a sufficient amount -- whatever that may be -- then start moving in. But do so with only a third of your cash. Then, as stocks continue to fall, as they almost invariably will, commit another third a few weeks later. Reserve the final third to use in the event that stock prices drop even more after your second round of purchases.

This tactic, known as averaging down, allows you to have your cake and eat it, too. You not only take advantage of a downturn, but you do so in a rational and responsible manner. This is why even the greatest investors use this approach, including Warren Buffett, who has gone on record saying that he likes it when the stocks he buys go down soon thereafter.

During the current correction, for example, I've already committed my first round of capital to shares of ExxonMobil, IBM (IBM -0.35%), Chipotle Mexican Grill (CMG -1.34%), and Bank of America (BAC 1.59%). Only ExxonMobil made the table above, but I believe that all of these companies exhibit traits that make them attractive buys right now.

3. Short-term pain for long-term gain
If you can't bear to see the stocks in your portfolio go down, then you have no business investing during a stock market correction -- for that matter, you shouldn't invest in a bull market, either. You can't call the bottom. And you'll probably be early. Even if you average down, in turn, your portfolio will show losses in the short term.

But you don't have to realize these losses. The trick is to ignore them until they evolve into gains. And ideally you want to give the positions years, if not decades, to season, as that will allow the law of compounding returns to work its magic.

This evolution will happen if you pick quality stocks and average down. But it won't happen if you then lose your cool and sell out prematurely. Here's how Buffett explained this in his 1987 shareholder letter, which he wrote in the aftermath of Black Monday, the worst single-day drop in stock market history up until that point:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

The stock market and the U.S. economy have recovered from every correction and downturn since the British surrendered at Yorktown in 1781. So if you've done the work by selecting quality stocks and averaging into them, then you have every reason to believe that your portfolio will benefit handsomely. At that point, you just have to give it the time and opportunity to do so.