When stock exchange price boards are a sea of red, it can be easy to take fright as an investor. But in fact, I think a stock market correction is a great opportunity for me to build my share portfolio in a way that could help me retire early. Here is how.
Mr Market
The way many people react to a stock market correction reflects how they think the stock market works – and I think it can be an unhelpful way of looking at things.
The famous investment writer Benjamin Graham thought about the market in his own terms. For him, ‘Mr Market’ was a person who offered him a price each day at which he could buy or sell shares. Graham’s crucial insight was that the fact that Mr Market offered a higher price one day, or a sharply reduced one the next, often had no bearing on the underlying value of a company.
Consider as an example Antofagasta. What drives its business? Its ability to pull metals out of the ground and sell them. Lots of things could go well or badly for such a business. Political risks in South America might reduce profit margins. Selling prices for metals like copper could soar – or collapse. Those things may affect the long-term ability of the company to make profits, which is what drives its value. But from day to day, on Graham’s analysis, a business like Antofagasta is not worth more or less just because its share price moves up or down. After all, if its shares drop 5% in a trading session on the stock exchange, in the absence of dramatic company news, Antofagasta is still the same business at the end of the day as it was when the opening bell rang.
Taking that approach, a stock market correction does not affect the value of my portfolio unless I decide to sell shares I own at the new, lower price. As I invest for the long term with the mindset of a buy-and-hold investor, I do not worry about the value of shares I own in my portfolio moving up or down in the short term. But market turbulence can work to my advantage in a very distinct way.
Quality on sale
Specifically, in a stock market correction, I would be hoping to buy high-quality companies for more attractive prices than before.
That can make a big difference to the long-term value of my portfolio. It can be driven by buying income shares at different prices.
For example, the insurer Legal & General (LSE: LGEN) is popular with many investors for its income potential. At the moment, the company pays a 7% yield. I already find that attractive and would consider adding the company to my portfolio. But over the past 12 months, the share price has moved around. It has been as low as £2.26 and as high as £3.10.
Yield is the annual dividend a share pays calculated as a percentage of the price I pay for it. So the yield I earn in future can move around a lot depending on how much I pay for my shares.
If I had bought £10,000 worth of Legal & General shares at £2.26, and reinvested the dividends each year, after 20 years I would have over £50,000 worth of shares. But if I had invested the same amount of money in Legal & General shares at their 12-month high price, it would take me 28 years to reach over £50,000 in value. In other words, the difference between buying my Legal & General shares at the high and low points over the past 12 months is that it would take me eight years more to reach the same portfolio value if I bought at the high price than if I bought in at the low point.
Stock market correction
But while share prices have moved up and down over the past year, a stock market correction could offer me even better value.
In March 2020, for example, I could have bought Legal and General — briefly — at £1.57 a share. At that price, I would now be earning a yield of 11.8%. For my total investment to hit £50,000 in value would take 14 years. In other words, to turn £10,000 into £50,000 by investing in the shares would take me half as long if I bought in the 2020 stock market crash as if I bought the shares at their most recent 12-month high.
Now, this example involves some assumptions. For example, I presume that the Legal & General dividend remains flat. But dividends can be cancelled or cut, something the firm did during the financial crisis. I also presume that the share price remains constant, which over the course of many years is unlikely. But what the example does show clearly is that simply by investing an identical amount in the same shares during a stock market correction, I could get to a particular financial outcome years faster thanks to the miracle of compound investing. That could help me to retire many years earlier.
Stock market timing
However, nobody knows when a stock market correction has hit bottom. No-one knew in March 2020 whether shares like Legal & General would get cheaper or more expensive in the coming months and years.
But while I do not think I can time the market, I can still take advantage of a stock market correction to boost my investment returns and bring my retirement forward if I choose. To do that, I would make a list of what I regard as attractive companies with outstanding long-term income potential. I would always diversify my holdings by investing in a range of different companies.
Then I would wait – maybe for years – until I could buy them at an attractive price. If a stock market correction comes along, I would take advantage of uncommonly low purchase prices while I could and fill my boots.
