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Stock Market Corrections Are Unfair

By Jordan Wathen - Feb 17, 2016 at 2:01PM

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A correction affects all stocks differently. Here's where to look for bargains.

Stocks go up, down, and right. The only direction they don't go is left -- time travel hasn't been invented, unfortunately.

The reality is that when stocks are going up, everything feels great. Long-time savers likely saw their net worth increase by more than their annual income in the bull market of 2013, for example, when stocks broadly rose and the S&P 500 Index (^GSPC -0.22%) jumped by 29.6%. Those are the kind of years that make investing feel easy -- the years when the wealth-building power of the stock market becomes plainly obvious.

2016 has started off poorly. The S&P 500 Index, as measured by a popular exchange-traded fund, has fallen about 8%, when adjusted for dividends.

The S&P 500 is a poor benchmark
By design, everyone's favorite market index includes only large-cap stocks -- roughly 500 companies that make up the bulk of market capitalization in the United States. By company count, though, the S&P 500 excludes more companies than it includes.

Mid-cap and small-cap stocks, which are excluded from the S&P 500, have started 2016 on much worse footing. Mid-cap stocks are down about 9.6% this year, compared to a negative 14.2% return for small-cap stocks. If you own shares of smaller companies, you're invariably feeling a little worse about your portfolio than the investor who only owns large-cap stocks.

Investors that are heavy in bank stocks are also feeling the pain. Financials and financial services stocks are the two worst performers this year, as volatility negatively impacts services companies, and falling interest rates have sent banks back into the doldrums. So much for rate hikes -- the market's favorite bet on interest rates, Bank of America, is down by 29% in 2016 alone.

The chart below shows year-to-date performance by market cap (blue) and by sector (ETFs of individual sectors that make up the S&P 500).

Notice that amid the carnage, consumer staples stocks have essentially gone nowhere since the beginning of the year. People tend to buy just as much soda, razor blades, and shampoo regardless of what happens on Wall Street. Investors also tend to flee to these stocks when the going gets bad elsewhere -- no fund manager gets fired for buying boring stocks in a downturn.

Use the chart above to score your current portfolio and guide your future investments. If you've been light on bank stocks, now might be an excellent time to start looking for a few to add to your portfolio. As legendary investor Jeremy Grantham has explained, "You don't get rewarded for taking risk; you get rewarded for buying cheap assets." Investors who have concentrated in low-volatility consumer staples stocks, or large-cap stocks, might want to think about venturing into smaller-capitalization companies. After all, you don't get paid for doing what everyone else is doing. However, if there is an over-allocation of financial services and healthcare in your portfolio, it might be time to consider diversifying with some companies in other sectors. After all, the entire market is down, so even the most stable companies can be found with varying degrees of discount.

Stock market corrections are inherently unfair, but the inequity can be used to your advantage. Shop around in bombed-out industries and company sizes you've been avoiding. You might just find your next multibagger in the carnage. 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Photo credit: 

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