All consumers like discounts. When products get cheaper one can buy more for the same amount of money, for every rational individual this will be positive. Investors, however; always react differently: when screens in dealing rooms turn into a sea of red as stock prices plunge, investors tend to become nervous and in the worst-case scenario they even sell large parts of their portfolios. At first sight, market corrections have many negative implications for investors, so why are rational investors glad about stock market corrections?
A stock market correction is when the market falls ten percent below its 52-week high and generally occurs once every year. Corrections are caused by sudden sell-offs in the market. Any number of events could trigger a market correction, from investors thinking the market is about to peak to sudden spikes in long-term bond yields. Whatever the cause, corrections are short-lived, typically lasting no more than eight weeks. More importantly, a correction does not mean that the bull market is at its end or that a recession is imminent. In fact, corrections are a natural and healthy part of the economic business cycle and by extension the market cycle.
A first way to look at a stock market correction is that it is the market pressing the reset button.
What is the advantage of decreasing stock prices?
A first way to look at a stock market correction is that it is the market pressing the reset button. Corrections help tamp the flame of irrational investor behavior that may fuel bull runs by reminding investors the market does not move in only one direction.
However, it is also possible to look at corrections in another way. As said in the introduction: consumers like discounts and sales. They want to buy products for the smallest price available, so when they see a discount, they can buy the same quantity for a lower price. Investors are on the opposite side and dislike price decreases because a lot of investors have geared their trading around the short term, or have heavily leveraged their account with the use of margin. However, when investors is in the market for the long-term, they should never forget that they can actually buy more for the same price once the correction took place.
A market downturn does not bother us. It is an opportunity to increase our ownership of great companies with great management at good prices. - Warren Buffett
As long as we are investing, we want to continue to benefit of low prices and discounts. This can be seen in the following example: suppose you are a long-term investor and you invest in an index with a dividend yield of four percent. The divided grows yearly with three percent and you re-invest the whole dividend. What do you prefer: The index increases the next day with 200% and never changes, or the index decreases with 67 percent the next day and never changes? Without hesitation, almost all investors will choose the first option, but are they right?
No, they are not right. What most investors forget is that they re-invest the dividend and that they can buy a lot more of the index once it has fallen with 67 percent. The growing dividend yield and the compound interest then facilitate a higher yield than most short-sighted investors would yield with the one-time 200% increase (see figure above).
So next time a correction happens, keep in mind that corrections are merely a way to make profits when others are not. There is an old adage on Wall Street that says: “Be fearful when others are greedy and greedy when others are fearful”. That simply means to have the courage to step in and buy when others are selling and be cautious when others are overly greedy.