This article was originally published on September 13, 2015, and was last updated on January 13, 2015.
Stock market corrections can be scary -- after all, who enjoys seeing the value of their investments fall by thousands of dollars? However, many investors don't realize that times like these are when wealth is really made. Smart long-term investors like Warren Buffett welcome crashes and corrections, so here are three pieces of wisdom from the Oracle of Omaha himself that you can apply to your own strategy and use this correction to set yourself up for the long run.
Don't panic and sell
I've recently written that the absolute worst thing you could do in a correction or crash is to panic and sell your stocks. If history is any indicator, stock market corrections and even crashes are a completely normal part of a healthy stock market, and even people who buy at the worst possible times end up winning over the long term.
During a correction, your losses are only on paper. However, if you decide to "cut your losses" and sell, they become real. As Buffett has said about investing, "Rule No. 1: Never lose money. Rule No. 2: Never forget rule no. 1."
There are certainly some valid reasons to sell a stock at a loss. For example, if something has fundamentally changed about a stock and your original reasons for buying it no longer apply, it can be acceptable to sell.
On the other hand, selling a stock that you still believe in for the long run because you're afraid it will go down more is one of the worst investment moves you can make. It's common knowledge that the main goal of investing is to buy low and sell high, but panic selling during a crash is the exact opposite of this. Buffett knows that in the vast majority of cases, the best way to invest is to buy and hold, no matter what the market is doing.
To illustrate this, consider that Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) stock price has increased by an average of 21.6% per year over the past 50 years while rarely selling its stock holdings, while the S&P 500 has averaged a 9.9% total return over the same time period -- and a big reason for this is Buffett's ability to invest wisely during the bad times. Meanwhile, a survey found that the average retail investor has only managed to earn a return of about 3% per year, precisely because they do the exact opposite of what they should do. Many people buy when everyone else is making money and stocks are expensive, then sell when it comes crashing down. Learn from the master -- don't be a buy high and sell low investor!
Buy good stocks cheaply
Instead of looking at it as an excuse to panic and sell, a market correction should be embraced as a time to stock up on your favorite stocks at a discount. In Buffett's words, "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down."
What he's saying is that investors should look at corrections the same way they look at a sale at their favorite store. As of January 13, the market as a whole is "marked down" by about 7% from where it was less than two weeks ago, so it's a good time to take advantage.
Wait a second. Couldn't the market drop even more? Of course, it could. Then there will be an even better "sale." That's why it's generally a bad idea to throw all of your money into a stock at any one time.
Let's say that you've got your eye on a stock that's trading for $50 per share and that you have $2,000 to invest. Instead of putting all of your money into it right now, maybe you could spend $500 for 10 shares. Then, if the share price happens to go down to say $40, you could spend another $500, which could now buy 12 shares. And if the price continues to drop, you can continue to accumulate a position, taking advantage of the lower prices with a concept known as dollar-cost averaging.
As Buffett says, "Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble." In other words, don't be afraid to put money into a falling market. You may not be glad you did it next week, next month, or even next year, but years down the road, you'll be glad you had the discipline to buy quality stocks while they were on sale.
But not all cheap stocks are worth buying
Finally, perhaps my all-time favorite Buffett quote is "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
If you take a look at Berkshire Hathaway's stock portfolio, you'll notice that most of the companies listed are either the leaders in their respective businesses or close to it. When market corrections happen, weaker companies in a sector tend to get beaten down more than the leaders -- but for a good reason. Stronger companies have the resources to ride out corrections better, and many actually emerge from the tough times in better shape than they went in.
As an example, consider two oil companies -- ExxonMobil and BP. Now, ExxonMobil is a great company. It has exposure to all aspects of the oil business, some of which do better when oil prices are down. And, Exxon is one of only three companies in the U.S. with an AAA credit rating, giving it virtually unlimited access to cheap capital to take advantage of any opportunities that present themselves. On the other hand, BP is a fair company right now, especially when compared to Exxon, with ongoing legal risk and a lower credit rating, just to name a couple of reasons.
So, even though BP's stock price has dropped further than Exxon's recently, I would be willing to bet that Buffett would still consider Exxon to be the better bargain.
Your correction playbook
Whether you agree with every aspect of Buffett's investment strategy or not, one thing is certain -- the man is good at getting through the tough times. In fact, the S&P 500 has had 11 losing years out of the past 50, and Berkshire Hathaway's share price outperformed the market in nine of them.
So, when the market gets ugly, it's time to hang on to what you have and be on the lookout for high-quality stocks trading at a discount. If Berkshire's 50 years of outstanding performance are any indicator, it's a winning strategy.