The stock market has had an erratic year. With only a 2% increase over the last 12 months, the leading FTSE 100 index is nearly at its level from one year ago. But the index dropped by about 10% between February and March, and then again from August to October. The typical definition of a stock market correction, which is a 10% decrease over a brief period of time, is virtually met by the magnitude of that loss.
Some stocks have performed significantly worse. For instance, JD Sports is down 41% from a year ago, Rolls-Royce stock is down 21%, and boohoo has lost 65% of its value.
How should we react when the stock market next corrects itself? We’ll strive to increase our wealth with it! How? Read on.
How to become wealthy
In theory, being wealthy as an investor is straightforward. There are three components to it. We must look for outstanding companies to invest in. Hence, we must purchase at a tempting cost. We also need to invest enough cash to make a difference in our financial situation. Even if we invest a very tiny amount, we might see an increase in the value of our portfolio, but expecting to become wealthy is not practical.
Two of the three things are essentially consistent. Regardless of stock market volatility, finding exceptional firms and investing adequate money require the same type of strategy.
The significant distinction appears when considering investments “at an attractive price.” We may make a lot of money if we can take advantage of a stock market correction to invest in the appropriate company at a good price.
How to value stocks
But what constitutes a tempting price? We believe that more investors would become wealthy if it were simple to tell.
For illustration, consider boohoo. Less than a third of what we would have paid 12 months ago allows us to purchase its shares. Does that imply that the company is currently worth about a third less than it was before? Perhaps the selloff was exaggerated, making boohoo’s current price a potential steal for our portfolio. However, with declining sales and earnings, it’s possible that even after a sharp decline, we still don’t find the boohoo price to be alluring.
We employ a relatively simple technique inspired by multibillionaire investor Warren Buffett to determine what constitutes an appealing share price.
We take into account the projected future earnings that a company will produce. Then we take into account the cost of holding onto our capital over time and compare that to its current valuation, taking into account its debt, which must eventually be repaid. If the current pricing is noticeably less expensive than what we believe the long-term value to be, we would find it to be appealing.
How we’d respond to a stock market decline
That clarifies our strategy for the upcoming stock market correction. Then, we won’t begin searching for alluring businesses. We should do that right now so that we are prepared to take advantage of opportunities when they arise.