It doesn’t seem like a positive when your portfolio drops in value. And it’s certainly not something that most of us would say we enjoy. However, there can be several benefits to stock market corrections. Remembering them can make enduring the drop less painful.
Why #1: Corrections create an opportunity to buy low.
For those of us maintaining a disciplined target percentage between stocks and bonds, a large enough correction can trigger a rebalance. For example, say your portfolio target was 60% stock and 40% bonds. If, during a correction, the market fell enough that your actual allocation dropped to 55% stock and 45% bonds, it would be time to rebalance. So you would sell 5 percentage points of the bond funds to buy more stock funds and return your portfolio to its 60% stock / 40% bond mix. Following this disciplined approach would automatically let you “buy low” during the correction. And when the market eventually recovered, you would own more shares of the stock funds and be further ahead financially.
Why #2: Corrections can allow you to reallocate your portfolio at a lower tax cost.
If you have holdings in your portfolio that are no longer optimal for your current goals or perhaps are higher cost than comparable funds available today, it can sometimes make sense to delay selling them to defer incurring the tax cost on the capital gain. When we have a correction, those capital gains are reduced and can sometimes be completely offset by other losses. So corrections can create the opportunity to make long-term improvements in your portfolio with less of your money going to taxes.
Why #3: Corrections put Roth conversions on sale.
We all love a sale. If you’ve been considering converting assets to Roth, the perfect time can be during a really deep correction. For example, say your traditional IRA was worth $100,000 pre-correction and was invested in 100% stock. If it falls to $80,000 and then you convert it, you only pay tax on the $80,000 value, not the $100,000. Then, when the market recovers, you have a Roth IRA that is completely tax free (after the 5 year holding period and age 59 ½) and fully returned to its original value and beyond. Of course, keep in mind that lots of other factors also play into the Roth conversion decision that are specific to each situation, and these could easily outweigh the relative value of converting during a market dip.
Why #4: Corrections make the long-term rate of return on stocks higher.
This sounds counter-intuitive, doesn’t it? But we’ve all heard about the relationship between risk and reward – if something is more risky, as rational human beings, we require a higher return to justify our investment in the asset. If stocks just went straight up at 8% per year, many people would put all their money into stocks. And quickly the price would go so high that the expected rate of return going forward would fall. So the volatility of the market that causes some people to perceive the stock market as too risky makes it more rewarding for those of us willing to tolerate the ups and downs with at least some of our portfolio.
Bottom line, we view market corrections as a normal part of the market cycle, events to be tolerated and not feared. And sometimes they even create some opportunities than can leave us better off financially.