What You Need to Survive the Correction

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When stocks nosedive and most people get afraid of the financial markets, great investors start looking for opportunities. But one of the most valuable lessons you can learn is that you don't have to buy at the first sign of trouble in order to profit from market corrections. In fact, if you're patient enough, sometimes you'll be rewarded with even bigger bargains.

When the sky falls
Last week's volatility has a lot of stock market commentators wondering whether it's time to head for the exits, for a variety of reasons. Among those who follow technical analysis, the fact that the S&P 500 closed below its 200-day moving average on Thursday, and failed to break back above it on Friday, is a negative sign.

Even those who look at the market from a more fundamental viewpoint see plenty to worry about. Over the weekend, master investor Seth Klarman argued that government manipulation had made him as worried about the world as he'd ever been. He's making disaster plays like betting on a huge collapse in the Treasury bond market, but he argues that with more typical protective portfolio moves like buying gold are now too expensive to be effective. Yet he's still putting money to work with specific stocks he finds undervalued -- even with the overall risk levels in the financial markets.

The most underrated virtue
If you're a value investor, then buying now on the market's dip may seem like the best move you can make. After all, with the S&P 500 already down more than 10% from its highs from just a month ago, you can already point to substantial savings from what you would have paid on most stocks back in April.

There's a problem with investing at the first sign of trouble, however. It's true that if you're right, and the market only makes a small correction, you'll have correctly called the bottom and bought on the perfect dip. But if you use up all your spare cash buying stocks now, you won't have any left to take advantage of even further drops later, if it turns out that the worst is yet to come.

The last bear market has many great examples of this phenomenon. Take the casino industry. During 2008, shares of MGM Mirage (NYSE: MGM  ) , Las Vegas Sands (NYSE: LVS  ) , and Boyd Gaming (NYSE: BYD  ) all fell steadily in varying degrees during the first nine months of the year. By the end of September 2008, each had lost between 60% and 70% of its value. With many believing that Las Vegas was doomed and that gaming would crumble, contrarian value investors might well have believed that the time was ripe to buy.

Yet although buyers were right about those companies' eventual prospects, buying in September 2008 would have proven far too early. MGM and Las Vegas Sands went on to lose almost all of their value by March 2009. And even though all three of those stocks have bounced sharply from their lows, those who jumped in too early still have losses in two of those three stocks -- and a mere 40% gain in Boyd, compared to the triple earned by those who waited until March.

You can't time the market, but...
Similarly, this time around, it's easy to look at big drops in stocks as buying opportunities. Green Mountain Coffee Roasters (Nasdaq: GMCR  ) has fallen 30% in a month, as some worry that its hypergrowth era is ending. After a huge resource-related run, Teck Resources (NYSE: TCK  ) has shed a quarter of its value in the last four weeks as Chinese economic growth appears to slow down. That trend, along with potential inflation in raw-materials costs and all the chaos among European stocks right now, has also fueled concerns about steelmaker ArcelorMittal (NYSE: MT  ) , pushing its shares down by a third.

If you're considering putting all your available cash toward buying stocks like these, let me suggest an alternative: Buy some shares now, but keep some cash handy in case these stocks fall further. That way, you don't miss out if the correction turns out to be mild, but you also have a chance to buy in even more cheaply later if market conditions worsen.

It's hard to be patient when good bargains become available. But given how irrational the market can get during gloomy times, waiting is sometimes the best move you can make.

Even the Oracle of Omaha is pushing the "sell" button. Find out from April Taylor which stocks were on Warren Buffett's chopping block.

Fool contributor Dan Caplinger has learned a lot about patience from his five-year-old daughter. He doesn't own shares of the companies mentioned in this article. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is a model of virtue.

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  • Report this Comment On May 24, 2010, at 11:29 AM, sept2749 wrote:

    So, what exactly do I need to "survive the correction"? If all you are saying is don't go hog wild buying just yet why write so many words. It's obvious! On the other hand I think it's solid advice to buy in increments in times like NOW!

  • Report this Comment On May 24, 2010, at 12:48 PM, fauxvix wrote:

    In other words (and as the experts have oft advised), put your eggs in multiple baskets. Hey Hey!

  • Report this Comment On May 26, 2010, at 3:20 PM, investmentcafes wrote:

    Thats the sad part the only investment advise given was....Wait...? And that passes for Advise.?

    My Take is use the downside to make money...which is so overlooked and underdiscussed like it's "TABOO" to have downside risk FOOLS at the have Health CARE insurance.?Car insurance.?..Home/Property Insurance.? Life Insurance.?..yet for some "FOOLISH" reason no Stock Insurance...hmmm..if the market is always Valued correctly then why 60% drop in 2008-2009.? what Fool are you listening too...personally it's sad no Mutual funds/IRA's..ETC offer downside protection to company 401k's like congress/SEC..ETc doesn't want the Public investors hedged..thats be wise...and with the expiring of Bush's Dividends tax cuts coming end of 2010..that will make exposure to riskier stocks that more attractive/ volatility..mark my words.!

    use RSW,SH..or some Options to hedge the downside..any portfolio,for long-term,thats unhedged is....."FOOLISH".!!!!

    Take care

    Happy Trails

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