Coping with a correction in the stock market

Correction is one of those words full of negative associations from school days when it signified how far short of perfection every individual had fallen.

So it is no surprise that a share market correction – such as the one the Australian market is now starting to pull out of, along with the US market as well – is often perceived very negatively.

After all, what good thing is achieved by having a market index fall until it meets the accepted definition of a correction with a ten per cent fall?

Stocks are on sale during downturns

The answer depends on your perspective but for the average person saving through their superannuation, a correction marks a time when stocks go “on sale’’.

As such, often the best returns within a long term superannuation fund are those in which stocks were progressively bought as they plumbed the absolute depths of a bear market.

Similarly, a buy and hold investor who keeps a cash reserve to buy more stocks during market dips will probably do well during a correction, depending, of course, on their time perspective and at what point they decide to start investing the cash.

Traders enjoy the wild ride

For traders it is a more complex situation and there is little escape from a long position held just before the market corrects, other than a carefully weighted stop loss exit to control the size of the loss.

However, skilled traders often revel in volatile markets, with whipsaw rises and falls providing much greater potential for making solid, short term profits than “boring’’ markets that gently rise and fall.

The real victims of a correction – and there are always plenty of them – are those who follow every market nuance and finally capitulate and sell out when the market reaches a time of peak pessimism, a time tailor made for buying rather than selling.

When to be fearful, when to be greedy

As that wise market sage Warren Buffett put it: “Be fearful when others are greedy and greedy when others are fearful.’’

Of course, it is easy to say keep your emotions in check but humans are emotional beings and getting tied in knots trying to time markets is not easy or everybody would be doing it.

Long term, mechanised approach the best

Which is why the long-term, mechanised, dollar cost averaging approach of the average superannuation fund which buys stocks at regular intervals is so powerful.

Sure, the fund will buy some stocks at the very peak of a bull market but it won’t buy that many, precisely because the fixed dollar amount won’t go as far.

It is when the market is at its depths or even after a sharp correction like the one that we have just gone through, that the fund “get greedy’’ and buys many more stocks for the same dollar amount, precisely because they are relatively cheap.

BHP a perfect example

Take BHP (ASX: BHP) as an example.

Not long ago at the start of October, BHP shares were trading above $35 each compared to now when they are trading much closer to $30 flat.

Your average index fund is now buying around 15 per cent more BHP shares at every purchase point than it was just a few weeks ago.

Sure, the outlook for BHP has deteriorated in the ensuing weeks as the oil and iron ore prices move sharply lower.

But in the very long term do you think the $35 BHP shares bought in October 2018 will have performed better than the almost $30 ones bought a few weeks later?

And in the short term, what about the person who bought the $35 BHP shares and sold them now at $30 as they worried about the outlook and the losses they had suffered?

The super fund will most likely find that the best results come from those shares bought in the dips with lower but still respectable results than those bought when the market was higher.