This article was updated on Jan. 13, 2016.
The markets are officially in "correction" territory, which is defined by a drop of more than 10% from the market's peak, which was reached in May 2015. The major stock market indexes are all down significantly from that high.
And if the recent volatile trading and plunging oil prices are any indication, further declines are possible. While a market correction can be frightening to even the most experienced investors, there is one thing you definitely don't want to do: sell.
In corrections, many investors are their own worst enemy
The point of investing is to buy low and sell high. Unfortunately, many investors let their emotions get the best of them, and they end up doing the exact opposite. When the market has a massive winning streak and everyone is making money, investors are tempted to buy stocks at inflated prices -- i.e., they buy high. And when the market corrects or even crashes, investors panic and sell when stocks are cheap -- that is, they sell low, turning paper losses into real losses.
Image source: Getty Images.
This has a devastating effect on the average investor's ability to generate wealth over the long run. To give you an idea of just how dangerous this behavior is, consider that a recent study found that the average investor has averaged a total return of just 2.5% over the past 20 years, while the S&P 500 has returned an average of 9.5%.
In other words, the average investor who started with $10,000 two decades ago would have turned that money into just over $16,000. Simply invested in an S&P index fund, that $10,000 would have grown to more than $61,000.
I'm not saying that you should put your money into index funds, but I am saying that a buy-and-hold approach should be taken during all markets -- bull, bear, and sideways.
Instead, look for bargains
When the market is down, the smartest thing you can do is hunt for bargains, acquiring shares of your favorite stocks while they're "on sale."
Sure, many stocks have fallen for good reason. For example, companies with lots of foreign-exchange exposure have seen some profits evaporate thanks to the strong dollar. And energy stocks should be lower because of the plunge in oil prices. On the other hand, there are many companies whose share prices have fallen for no reason other than the overall market sell-off.
It's impossible to know (or even accurately estimate) where the bottom will be. For all we know, the Dow Jones could fall another 2,000 points or more before this correction is over. Or we could have already reach the bottom, and the market could rebound immediately. Nobody knows.
However, nobody ever went broke by acquiring shares of rock-solid businesses at good prices -- and there is no better time to do this than during a crash. After all, people who had the presence of mind to buy during the 2008-2009 crash could have bought shares of Google (GOOG -1.10%) (GOOGL -1.23%) for as low as $124 (both share classes are over $700 today), US Bancorp (USB 2.56%) for $8 ($39 today), and Starbucks (SBUX 0.53%) for $3.50 ($59 today). None of these companies was ever in danger of going bankrupt as a result of the financial crisis, yet they were trading at fire-sale prices just like the rest of the market.
The same logic applies today, although the discounts aren't quite as good. US Bancorp is still one of the most solid banks in the business, with excellent asset quality, strong growth, and some of the best profitability metrics in the business. Warren Buffett has been a fan of US Bancorp for some time now, and for good reason: It consistently delivers for investors in good markets and bad. Starbucks has grown tremendously and is still putting up growth-stock like numbers. During the past year, revenue has increased by 18%, and the company just produced its most profitable year yet. And during the bad times, Starbucks' low debt levels and fiercely loyal customer base will allow it to survive anything the market throws at it.
Finally, Google has a dominant market share in its core business and has almost no debt to weigh on it if times get tough. Now, I won't say that Google's business is "crash proof," but how many other large-cap companies can say they grew their revenue by 77% in the troubled period between 2007 and 2010?
The real money is made during the bad times
Look, I get it. My own portfolio is down by more than 10% over the past couple of months, and it's not fun seeing all those red numbers on my monitor in the morning. However, these are the times when long-term wealth is really created.
To illustrate this idea, consider the investment style of Warren Buffett: hunting for the stocks of great businesses at bargain prices and planning to hold them forever. (Of course, it's a little more complicated than that, but that's the general idea). It's common knowledge that Buffett has produced some of the best long-term results in history, but many don't realize that Berkshire Hathaway's investment portfolio often underperforms the market -- particularly in years when the S&P performs strongly. However, the S&P 500 has finished in the red in 11 of the past 50 years, and Berkshire's investments beat the market in every single one. Over the long term, this is a big contributor to Berkshire's success.
So, instead of panicking and selling your stocks, now is the time to dig your heels in and consider making some smart buys. It may be scary now, but you'll be glad you did it.
