At the time of this writing, the Nasdaq Composite (^IXIC 0.56%) is down 9.4% from its 52-week high, while the S&P 500 (^GSPC 0.35%) is down 6%.
While we are nowhere close to a full-blown market crash, the Nasdaq is close to correction territory, which is a drawdown of at least 10%. A crash is usually defined as a swift sell-off of at least 20%, and a bear market is a prolonged decline of more than 20%.
No one likes losing money. But stock market sell-offs and bear markets can present tremendous buying opportunities for long-term investors.
Here's how to navigate a sell-off, and how you can use periods of pessimism to build lasting generational wealth.
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The pendulum swings
Economist Benjamin Graham, author of the 1949 book The Intelligent Investor, famously wrote: "In the short run, the stock market is a voting machine. But in the long run, it is a weighing machine."
This means that short-term movements in stock prices have nothing to do with a company's intrinsic value. They're merely representative of whether the stock is in or out of favor.
During bull markets, investors are optimistic and may be willing to pay a higher price based on a company's growth potential. During bear markets, investors are pessimistic and want to pay less for a company based on its value or potential.
The key is to invest in fundamentally sound businesses that can grow over time, rather than using a stock's price as a yardstick for whether it is worth buying and holding or not.
In a bull market, both good and bad companies see their stock prices go up. But in a bear market, even the best companies can sell off simply because their near-term outlook is weak.
Understanding market forces
In his book The Psychology of Money, Morgan Housel discusses the importance of knowing what game you're playing. He describes the stock market as a field upon which multiple games are being played simultaneously. There are traders versus investors, institutions and individuals, risk-tolerant folks with ultra-long-term time horizons, and retirees looking to preserve capital and generate passive income.
All these factors are at play and can pull the market in different directions. A stock can stay beaten down for an extended period simply because traders don't think it will do anything in the near term, and then suddenly rocket higher once the narrative changes.
In comparison, some stocks can become Wall Street darlings and fetch consensus favorable ratings from analysts, which can stretch their valuations. As Warren Buffett famously said: "You pay a very high price in the stock market for a cheery consensus." This means that if a stock is well known and liked, chances are it isn't going to be cheap.
Using time to your advantage
The most powerful tool any investor has is time. Time can transform steady savings and mediocre annual gains into sizable wealth.
Consider that an investor who starts with nothing but saves $500 a month for 30 years and averages a 10% annual gain per year will end up with $1.13 million, even though the sum of their monthly savings is just $180,000. Meanwhile, an investor who starts with $180,000 upfront and earns a whopping 20% per year over 10 years ends up with roughly the same amount -- $1.11 million. So even though the first investor had nothing and earned a far lower annual return, they were able to achieve the same end goal because they had more time.
When the market sells off, it's important to remember what the end goal is, rather than getting caught up in the volatility. For individual investors, the end goal isn't to try to beat the market this quarter or year, but to use the market to help compound your savings over time.
When excellent companies sell off, investors who regularly put savings to work in the market can acquire even more shares of the companies they like. In other words, it's a way to use investors voting against the market by selling stocks to your advantage -- trusting in the might of the long-term weighing machine.
Use bear markets to build positions in top companies
Volatility is simply the price of admission for unlocking the stock market's compounding effects. Even so, stock market sell-offs are brutal. Focusing on the big picture is challenging when equity prices are bleeding red and your portfolio balance is decreasing.
We're all human, and personal finance can be emotional. After all, investing involves your hard-earned savings, money that you've chosen to defer spending in favor of growing over time. So, when that money loses value, it can really hit home.
By using stock market sell-offs to acquire even more shares of quality companies, you can accelerate the pace of compounding and grow closer to reaching your financial goals. However, it's worth remembering that regardless of whether the market is going up or down, it's best to invest in companies you truly understand and that you have the conviction to hold through periods of volatility.
