There is no one-size-fits-all formula for investing, but there are certain rules all good investors should live by. Periods of high volatility tend to throw investors off their game, and with a lot of the so-called "experts" predicting a market correction any day now, it's more important than ever to make sure you have a plan to follow. Here are three principles to keep in the back of your mind so you know what to do (and what not to do) if things should get rocky.
You've been doing your homework, right?
Just because you loved your stocks when you bought them doesn't mean you should blindly hold them forever. While I always stress investing for the long term, you should catch up with every company in your portfolio on a regular basis. You don't need to become an expert, but spending a few hours each month familiarizing yourself with the current state of your stocks should become a habit.
How does the valuation compare to the rest of the market and to the company's own historical average? What major news has come out of the company in the last few months? Most importantly, are the reasons you loved the company in the first place still valid? You should be able to answer these for every stock in your portfolio.
If you've done your homework, you should love every stock in your portfolio on a long-term basis. So don't get suckered into selling your shares just because the overall market drops. It's important not to panic when investing -- even if the drop is specific to one of your stocks, like when Bank of America reported a $4 billion "miscalculation" earlier this week. If you still believe in your original reasons for buying it, there is no need to run for the exits.
Look at the panic selling that took place in late 2008 and early 2009. People were selling their stocks left and right in an effort to salvage what they could.
As an example, check out the price chart of Harley-Davidson below. As you can see, there was massive selling between September 2008 and March 2009, which caused shares to drop from about $40 to below $10. However, those investors who kept their heads and still believed in the company held on, and not only have they made back what they lost, but they've enjoyed a total return of nearly 80% since before the crash! Imagine if you had panicked and sold at $10.
Keep some cash handy
This brings me to perhaps the most important point. Always, no matter what, keep some cash to invest. I always aim to keep at least 5% of my portfolio in cash, but there is no set rule for this. Some cash is better than none, so if you're fully invested, you don't need to sell anything -- just consider keeping some of your new deposits on the sidelines.
Think of cash as a hedge against your stocks dropping. When the share price goes down, your cash can buy more shares. In terms of buying stock, cash becomes a more valuable commodity during a correction.
Given that we already love our stocks for the long term, when a correction does come, why shouldn't we take advantage and buy more shares at a lower price? Find someone who actually added to their positions in early 2009, rather than panic-selling. How's their portfolio doing now?
The Foolish bottom line
The point to remember here is that good companies will bounce back from market corrections, no matter how severe. Both the S&P 500 and Russell 2000 indexes have made back their losses and then some from every recession and correction in their histories, including the most recent one.
Once you've made sure you believe in your stocks for the long run by doing your research, it's important to your long-term returns to start setting some cash aside to take advantage of buying opportunities that may come up. And, whatever you do, don't sell good companies into a correction!
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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