As of Tuesday, Feb. 6, the stock market briefly dipped into a correction, which is generally defined as a drop of 10% or more from the highs. Although the speed of this correction may seem scary, it's important to take a step back, assess the situation, and come up with a game plan.
We're in a correction -- and it's about time
This may feel like a stock market crash, simply because of the speed with which the market has dropped. After all, 1000+ point single-day drops in the Dow Jones Industrial Average can be quite scary.
However, this is not a crash, it is simply a market correction. When the U.S. financial system was on the brink of collapse in 2008 and the S&P 500 lost more than half of its value, that was a market crash. In fact, in the span of just a week-and-a-half in early October 2008, the S&P lost 23%.
Not only is the current situation a correction, not a crash, but (so far) it is a fairly mild one. A correction is generally defined as a drop of 10% of more in the major stock indices, and while they briefly dipped below that threshold, as of this writing (9:40am EST on Tuesday, Feb. 6) the Dow Jones Industrial Average is down 8.5%, the S&P 500 is down 7.8%, and the Nasdaq is down 7.2% from the closing highs. So, we're technically not even in correction territory anymore.
To be clear, the market could certainly continue to fall. There's no way to predict whether there's more downside ahead. Just remember that corrections are part of a healthy stock market.
After the tremendous bull run of the past few years -- especially since the 2016 election -- we're just not used to seeing corrections anymore, so it's important to take a step back and realize that the sky isn't falling.
Rule number one: Don't panic and sell
Over the past 30 years, the stock market has generated annualized returns of 10.2%. However, the average stock mutual fund investor has achieved less than 4% annualized returns during the same time period, according to Dalbar.
One of the primary reasons is that investors are emotional beings and tend to act impulsively to market moves. When the market is soaring higher and higher, that's when they throw all of their money in. When the market drops rapidly, they panic and sell, trying to "get out while they still can." It's common knowledge that the central objective to investing is to buy low and sell high, but in reality, many investors do the exact opposite.
Keep a cool head, and don't sell into a weak market. You'll thank yourself later.
Rule number two: Look for long-term bargains
While it's not a smart idea to try to time a market bottom, it is a smart idea to try to find attractively valued stocks that will do well over the long run.
What's the difference? If you buy great companies after stock prices fall, you don't need to care whether the market has bottomed, or if it continues to decline.
I recently wrote an article about finding stocks that tend to do just fine during tough times, but also have excellent long-term growth potential. As one example, I mentioned healthcare REIT Welltower (WELL -0.23%). This is a defensive type of real estate investment, as people need healthcare whether the economy is good or bad, and thanks to the market correction and sector weakness caused by interest rates, the stock is trading near its 52-week low and has a massive 6.2% dividend yield.
Sure, if the market continues to crash, or interest rates rise faster than expected, Welltower could certainly go down a bit more. But from a long-term standpoint, I don't care. In fact, if that happened, I would probably be inclined to buy even more.
This is just one example, and similar logic can be applied to solid companies with strong fundamentals that are simply trading at a discount.
The Foolish bottom line
One of my favorite Warren Buffett quotes of all time is, "Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble."
In other words, market corrections and crashes should be looked at as opportunities, not as reasons to panic. Take a deep breath, start looking for attractive entry points into rock-solid stocks or funds, and take advantage of the correction. And this is even better advice if this correction ends up turning into a crash. Ask a room full of investors if any of them wish they had bought more stocks in 2008 and 2009. What do you think the response will be?
The bottom line is that the scariest times in the stock market are often the best times to buy, from a long-term perspective. When the market is still volatile, it can certainly seem scary to throw more money into the mix, but in 10, 20, or 30 years, you'll be glad that you did.