Managing Stock Market Corrections

The term “stock market correction” implies that something is wrong with the stock market and that a massive selloff is needed to bring stock prices back to reality. What is most troubling about these situations is the speed at which they occur. In a matter of weeks, a market index can lose five percent or more which is enough to scare even the boldest of investors. A correction, however, does not necessarily need to spell doom. Think of it as a chance to purchase your favorite companies at discount prices.

When the stock market sells off, oftentimes good companies are punished along with the bad. Solid, blue chip companies with strong balance sheets, income statements and cash flow statements are punished along with those producing little to know income or cash flow. For example, company A is developing a social media platform for inventors who use solar powered 3D printers in developing countries. The company posts negative earnings and negative cash flow yet it has attracted a great deal of investor interest. As such, its stock price has soared. Company B sells consumer products domestically and generates both consistent earnings as well as cash flow. Additionally, it offers a solid cash dividend each quarter. Both companies offer something: company A is innovative and could one day become a true global player while company B is a consistent performer. In a stock market correction, company A is likely to lose a significant amount of value since it is risky and largely driven by speculation. Valuing a company like this becomes difficult without solid financial numbers. Company B may also suffer a decline, albeit a less intense one. However, the financial performance of company B has not changed and is therefore being punished as a result of an overall fear of stocks.

So what should one do? Investors with a long term investment horizon argue that investing in company B during a stock market correction makes the most sense. In the long run, the company should be fine since it is likely to post strong results. Investing in company A is riskier and without solid numbers to support its valuation, there is no telling where the company’s stock price will settle. Unfortunately, a company that is based on speculation does not have the luxury of a long term time horizon.

 

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com .

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