Coping with corrections

Investors’ nerves are still taut after the big stock market sell-off in August. That’s understandable; at one stage there appeared to be a real danger that the correction could turn into a rout. The only move that put a brake on the slide was the well-publicized action by central banks in several countries to pour money into the financial system to ensure liquidity and a surprise decision by the U.S. Federal Reserve Board to cut its discount rate.

The blame for the sudden loss of investor confidence has been laid at the feet of the U.S. subprime mortgage market and there is no doubt that growing housing defaults in the U.S contributed significantly to world-wide nervousness over a possible credit crunch.

My view is that the subprime debacle was the proximate cause for the market turmoil we experienced but if it hadn’t surfaced at this point there would have been some other trigger. The plain fact is that bull markets don’t last forever and this one is getting pretty tired. Whenever major indexes hit new all-time highs, it’s time to take a close look at your holdings and reassess your position. There’s never been a record high without a pull-back close behind.

Hopefully, you’ve built some cash reserves, as I advised readers of my Internet Wealth Builder newsletter to do in mid-June when I wrote: “I expect this summer to be as volatile in the markets as a thunderstorm in a heat wave…If that prospect makes you uncomfortable, take some gains and build cash reserves over the next few months. By the time September comes around we should have a better idea where we’re heading.”

So what should you do if we see a repeat of the August jitters? Here are some of my general rules about dealing with market corrections. Keeping in mind that nothing about investing is carved in stone, I’ve also included some exceptions to these rules for special situations.

General rule: Don’t sell into falling markets. The natural tendency when markets are plummeting is to get out at any price. That’s usually a big mistake. Markets typically overcorrect in these situations. By selling into the frenzy, you risk being taken out at an unacceptably low price. As we saw several times this summer, triple-digit losses are often followed by triple-digit rebounds. If you want to get out of a stock, sell into those rallies.

Exception: In cases where you still have a large capital gain, even after the a selling bout, you may want to take some profits.

General rule: Don’t sell thinly-traded securities when markets are tumbling. Stocks that trade infrequently are highly vulnerable when markets sell off. That’s because a trade of just a few hundred shares can move the price sharply lower. Bargain hunters are always lying in wait for careless investors who enter a market order on an illiquid stock. They’ll cut the knees out from under you if you aren’t careful.

Exception: If you feel you absolutely must get out of a thinly-traded position, place a strict limit order. Otherwise you risk being whipsawed.

General rule: Buy quality stocks when they’re down. For example, during the August sell-off financial stocks took a big hit because they were seen as being particularly vulnerable to the subprime mess. At one stage, the S&P/TSX Capped Financials Index was off 7.6 per cent from its May high of 226.15. That index is made up of Canada’s largest banks, insurance companies, and wealth management firms. Does anyone really expect they won’t recover from this setback and go on to new highs in the next few years?

Exception: Because we don’t know how low is low, don’t spend all your available money immediately. If you’ve had your eye on a good stock and it comes within your target price range, commit half your allocation to buying shares. If the price drops further, you can average down.

General rule: Maintain a proper portfolio balance. Here I’m repeating a basic principle that I’ve been preaching for years, but often people forget it in both good times and bad. For example, earlier this year we saw investors dumping their bond holdings as concerns over rising interest rates and inflation took their toll on prices. That turned out to be a mistake. As usually happens, government bonds rallied as stocks sold off and investors fled to safety. As of Aug. 22, the Scotia Capital Universe Federal Bond Index was ahead one per cent for August. That may not seem like much but it was a lot better than riding the TSX, which was down 7.7 per cent for the month at that point.

Exception: None. Asset allocation is one of the fundamental keys to investment success and should never be sacrificed on the alter of short-term expediency.

General rule: Maintain perspective. Triple-digit stock market losses look scary and I’m not minimizing the seriousness of the situation for a moment. But some perspective is required. On Aug. 9, the Dow fell 387 points, a 2.8 per cent decline. That’s significant but it doesn’t come anywhere close to some of the one-day losses we’ve seen in the past. For example, on Oct. 19, 1997 the New York market fell over 20 per cent on a single day, wiping out about $1 trillion in wealth in the process. Now that’s a crisis!

Exception: If you are overly exposed to stocks, and especially if you are leveraged, you have good reason to worry. You need to take steps to redress the situation before the next shock wave hits. But do so in a rational manner – don’t make a bad situation worse. See my earlier rules for how to proceed.

The bottom line is that no one is comfortable when markets suddenly correct. But if you have a well-balanced portfolio and keep your head, you can keep the damage to a minimum.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to