Skip to main content

It was quick, and didn’t even hit official correction status, but the stock-market drop provided a nice test to prepare us for next time.

So long, stock market correction. We hardly knew you.

The S&P 500 bounced again on Friday to another record high, of 2018.05, up about 200 points from a mere two weeks ago, when it wallowed in the depths of despair.

The best part about the lightning-fast recovery? It gives us a chance to sift through our reactions to the turbulence of the past six weeks while the memories are still fresh and figure out what we did right and what we did wrong.

It is certainly easy to dismiss the period as a minor blip that might not be worth any reflection. At its lowest point during the downturn, the S&P 500 was down as much as 9.9 per cent from its high in mid-September, on an intraday basis. If you're splitting hairs, that's not even an official correction, which usually requires a decline of 10 per cent or more.

Nonetheless, the downturn was the biggest setback in three years. Certain elements of it – 90 per cent of stocks in the S&P 500 fell, the volatility index spiked and U.S. Treasury bond yields dropped suddenly – raised some frightening comparisons to the dark days of the financial crisis.

It challenged our commitment to the stock market, but possibly made us better investors in the longer run.

How so? I figure there are three key takeaways here.

1. Buy fear.

Calling the bottom of a market downturn is impossible for all but the luckiest investors, but it helps if you can gauge what the overall assessment of the market is – and when fear is the overriding emotion, fight against it.

This is more art than science, but there are usually plenty of clues to suggest that fear has become pervasive.

Big blow-off days when the S&P 500 is in free fall suggest that investors are bailing out at any cost. On Oct. 15, the S&P 500 fell as much as 55 points – its worst one-day dip in three years. That day marked the bottom of the downturn. Big, blaring attention given to the stock market's correction can also help. When newspapers make it their front-page story with scary charts – cough! – you know a buying opportunity is coming.

2. Know your risk tolerance.

Consider the latest downturn a valuable test for what will happen again and again. After all, corrections tend to arise every year, on average.

The problem with markets that rise without any significant setbacks for a long time is that we lose sense of the fact that stocks are risky, especially in the near-term. In a rising market – especially today's, where just about every stock is a winner – we tend to think that we're investing geniuses who can't possibly lose money.

The danger is that our portfolios can become lopsided, heavily tilted toward equities, when a better mix with bonds and cash is a safer bet. The downturn handed us an assessment of just what sort of volatility we can handle.

3. Avoid big bets.

No one can predict the future. At the start of the year, bonds were heading into a world of pain as yields rose and prices fell; they've since emerged as big winners. Remember when gold was touted as a great bet against the onslaught of inflation? Well, no inflation is in sight and gold is in the dumps.

While grand, sweeping investment themes can generate spectacular returns when everything lines up according to plan, they can also backfire in a big way when the future doesn't play along.

The correction illustrated this quite nicely. Betting heavily on stocks heading into the downturn provided a painful lesson in what happens when markets turn south and your portfolio withers; and bailing out of stocks after a 10 per cent decline, expecting that worse is to come, has provided an equally painful lesson in what happens when stocks rally and your money is left on the sidelines.

Maintaining a dull, balanced portfolio won't provide brilliant conversation at dinner parties, but it will get you through the next correction.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe