A correction in the stock market is usually defined by a drop of 10% to 20% in major indexes, such as the S&P 500, Nasdaq Composite, or Dow Jones Industrial Average (DJIA). While it's not as dramatic of a decline as stock market crashes, corrections can still wipe away a decent amount of portfolio value. Stock market corrections may cause some people to get a little nervous when they see their portfolio, but it shouldn't be an occasion for panic. In fact, there are valuable lessons to learn during stock market corrections. Here are three of them.
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1. They're inevitable
I hate to be the bearer of bad news, but unfortunately, stock market corrections are inevitable. If you're going to invest in stocks, you might as well get comfortable with corrections because they happen relatively frequently -- roughly one every two years. In the S&P 500, corrections of more than 10% happened 10 times between 2002 and 2021.
The one thing you want to avoid doing when corrections happen is overreacting and panic selling. If you're a long-term investor and investing in great businesses, short-term drops shouldn't be too much of a cause for concern. Understanding that stock market corrections come with the territory can help you avoid stressing when they occur and focus on how you can use them to your benefit.
2. Dividend Aristocrats can help hedge against market corrections
Dividend Aristocrats are companies that have increased their yearly dividend payout for at least 25 consecutive years. Being able to not only maintain your dividend but also increase it over a long time span shows your business has been able to keep things going despite rough economic times. Any company that has survived the past two decades has made it through the tech bubble collapse (2000), the Great Recession (2008 to 2009), and the beginning of the COVID-19 pandemic (2020).
Although the value of your investments may decline on paper during stock market corrections, owning Dividend Aristocrats ensures you're still making money despite what the stock price is doing. And if you want an extra sense of security, you can look into Dividend Kings, which have increased their dividends for at least 50 straight years.
3. Use corrections to lower your average cost basis
Your cost basis is the average price you paid for shares of a particular company or fund, and it determines how much profit you make when you eventually sell the shares. Let's assume you buy 10 shares of a company at $200, 10 shares at $180, and 10 shares at $150. In this scenario, your cost basis would be just over $176:
- 10 shares at $200 = $2,000
- 10 shares at $180 = $1,800
- 10 shares at $150 = $1,500
- $5,300 divided by 30 shares = $176.67
If you eventually sell those 30 shares for $250, you'll pocket just over $73 in profit per share. When stock market corrections happen, and stock prices begin to drop, instead of panicking, you can view it as a chance to buy some of your favorite investments at a "discounted rate." If you were willing to invest in a company or fund at $200 per share, you should be willing to invest in it at $150.
