Stock market corrections can be brutal. At its 2023 low, the Nasdaq composite fell more than 32%, while high-flying growth stocks suffered even worse.
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That’s why it’s critical that investors have a proven plan for how they will manage their stock portfolios during corrections. Following a buy-and-hold strategy can wipe out years of gains in a short time.
There’s also the important caveat that the beloved stock market leader that is the pride of your portfolio can end up being a millstone that weighs on your returns.
“Most stocks fall during a bear market, but not all recover,” IBD founder William J. O’Neil wrote in “How to Make Money in Stocks.” “If you hold on through even a modest bear market correction, you could be left with damaged goods that may never return to their former highs.”
A good example of this is the performance of Cisco systems (CSCO). Computer networking stocks reached an all-time high of 82 in March 2000. Although they have recovered from the subsequent low of 8.12 in October 2002, even 22 years later they are still nowhere near their old high.
What to do during a stock market correction
First of all, avoid buying stocks during a downtrend. This will help avoid falling into a bear market trap. Reversals can be particularly serious at this time.
It is also risky to hold a stock during a stock market correction. This is because declines in the major indices drag the majority of stocks down with them.
To make money in the long term, protecting profits is crucial. Consider selling your weaker positions, especially if you are incurring a small loss or breaking even.
You should always sell if a stock is 7% lower than what you paid for it. But selling earlier can pay off if the market is weak as a capital preservation strategy. The 50-day moving average is an important benchmark. If a stock falls sharply below this level in high volume, it is another important sell signal.
You should also keep an eye on your strongest positions. Maintaining gains is important when signs of trouble arise. Investors should not be afraid to take profits because there will always be opportunities to buy back market leaders.
An important point that is often overlooked even by experienced investors is setting a target price for all shares still owned. This is critical if we want to prevent healthy gains from turning into painful losses. A defensive sales price takes some of the emotion out of the equation – a key to preserving mental capital.
For example, if you have gained 20% in a stock, you may choose to sell if the gain drops to 10%. Having a hard line in the sand protects investors from dithering at the worst possible time.
Do not forget this important point for future profits
It’s all too easy to switch off and disengage from the market when a correction is underway. This is a dangerous mistake because a market bottom can catch you unprepared.
One must keep a close eye on the market and build a robust watchlist of top stocks. Look for names that exhibit unusual relative strength. The fact that a stock is holding up while the broader market is falling is often a good indicator that the stock is ready to show leadership when an uptrend inevitably resumes.
This article was originally published on August 12, 2022 and has been updated. Follow Michael Larkin on Twitter at @IBD_MLarkin for more growth stock analysis.
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