Most people dread the possibility of a market pullback. The wealth destruction and the drop in their investment account balances cause panic and fear. These things do happen, and the market will have a major pullback, but predicting when is a fool’s errand. Instead, its time to not only accept a market correction but to go one step further and wish for it.
Healthy Markets Fall
A healthy market moves up and down on its persistent path onward and upward. This path is normal, and we should be more worried if the market didn’t have these natural pullbacks to slow down a hot market. But as I mentioned, many do not see this as a healthy sign. They see a market decline as the end of an era. I see it as the beginning of some of the best investment returns you will ever see.
Shown is a graph of US Real GDP and the Wilshire 5000, an index of 5000 stocks and a good proxy for the total stock market. The shaded bars are recessions, most accompanied by a substantial market pullback.
Compound interest is most dominant over a long time horizon. Because of this, the ideal scenario is to have large savings and investment returns early in your retirement planning. This timeline builds up your portfolio fast with a bull market at the beginning, and compound interest can take over to push you over your retirement goals.
How to Take Advantage of a Correction
Preparing to take advantage of an upcoming bear market or market correction is easy. First, make sure you have a savings plan already in motion and one that has a high savings rate. Consistent savings will guarantee that you are buying all the way through the dip including the bottom. You don’t want to miss out on these sweet returns trying to time the market by attempting to predict the bottom. The high savings rate will ensure that you are buying big chunks of the market at the bottom, not just taking a nibble of the future high returns.
Next, you should be following a version of the Four Step Savings Plan and paying off debt first. Try to accomplish this goal as soon as possible so that you can deploy all of your available resources toward savings and not debt repayment. Having minimal or no debt will give you the most bang for your buck when the market falls.
Finally, be invested. You can only take advantage of the post-crash upswing by having money that you are saving allocated toward stocks. If you have a high savings rate and are keeping it in cash, you will miss the downturn, but also the large returns that quickly follow.
So to recap, to take advantage of a correction:
- Have an automated savings plan in place
- Have a high savings rate
- Invest in stocks now
- Pay off debt so that all savings go to investments
These tips are no surprise to the savvy seeker of financial independence. This process is how you achieve financial freedom. The difficulty during a market correction is to fight your own emotions to sell. It may be easy to say that you are immune to the fear that surrounds a market correction, but many other non-market factors raise their heads when the market falls.
Lemons into Lemonade
The reality is that a recession typically accompanies a market correction and recessions are no fun. Your compensation may be cut either partially or entirely. Family and friends may have difficulty paying their bills putting pressure on you to help. Your account balances will plummet.
Overall, this is not a happy time. In 2008, families lost jobs, homes, and financial security. Like past recessions, in the next recession, many will not be able to take advantage of the ride up because they don’t have a high enough savings rate to weather any financial hardship and still add to savings.
These are the times when your willpower is tested. I hope that you are not only prepared financially for a downturn, but also have the knowledge and comfort in financial history to know that the market will return. You can turn what many deem a horrible situation into one that can bring you a lifetime of happiness by giving a substantial positive jolt to your retirement savings.
This opportunity for the beginning of a bull market is why I catch myself daydreaming of huge market declines. Being young and in the accumulation phase of my path to retirement, a bear market would hit the reset button on the market and allow me to invest the bulk of my savings at the beginning of a bull market. The dream of any investor.
Graph Source: Wilshire Associates, Wilshire 5000 Total Market Full Cap Index [WILL5000INDFC], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000INDFC, January 31, 2018.