After a lucrative bull market for many investors, the stock market is entering what many deem correction territory. A stock market correction happens when a stock falls by 10% or more from its recent 52-week high, and that's exactly what has happened to the S&P 500, one of the most popular index funds that track the 500 largest U.S. companies.
As the stock market enters correction territory, here are three vital lessons that can be learned.
1. Bull markets don't last forever
Investors often use long periods of consistent market moves to categorize it as either a bear market or a bull market. Bear markets are generally defined by a steady decline in stock prices, while bull markets are defined by a steady increase. In February and March 2020, during the early stages of the COVID-19 pandemic, stock prices plummeted, with the S&P 500 dropping more than 33% from its pre-pandemic peak.
On March 20, 2020, the S&P 500 reached its lowest pandemic point, and from that point until Dec. 31, 2021, the stock market experienced what many would consider a bull market, with the S&P 500 increasing more than 106% from its March 2020 low point.
If it's one thing that's been consistent through the history of the stock market, it's the fact that volatility is inevitable, and neither bear nor bull markets last forever, as evident by the most recent movements.
2. Cash is an important asset
While cash shouldn't be the bulk of your financial portfolio, it plays an important role and should be part of it. You should aim to have an emergency fund set aside -- preferably three to six months' worth of expenses -- but once that's accomplished, you shouldn't ignore the benefits cash can play within your brokerage account.
As stock prices drop during stock market corrections, you can view this as a way to grab your favorite investments at a "discount." If you were willing to invest in an asset at a certain price, and it drops below that, then it could be a chance to increase your holding and lower your cost basis.
For example, let's imagine you purchased 10 shares of the Vanguard S&P 500 ETF (NYSEMKT:VOO) when it was priced at $439 on Jan. 4, 2022. When the price dropped to $394 on Feb. 22, 2022, instead of this being a time to be alarmed, you could have viewed it as a chance to grab more shares at a better bargain.
On Jan. 4, your cost basis would've been $439 per share, but had you purchased 10 more shares on Feb. 22, your cost basis would've dropped to $416.50 -- which could increase your per-share profit whenever you decide to sell.
However, the chance to increase your holdings at lower prices is only possible if you have cash readily available to use. If you don't have any nonemergency fund cash at your disposal, the only way to take advantage of these drops would be to sell some investments, which isn't usually the best idea.
3. Long-term investors shouldn't be anxious over short-term movements
Focusing on the long term is a key to success for many investors. In the short term, you should try your best to not get too high on the highs or too low on the lows. An unrealized gain is an increase in the value of an investment you own but have not sold, and an unrealized loss is a decrease in the value of an investment you own but have not sold -- and that's a clear distinction. Your gains and losses only exist on paper until you decide to sell an investment.
If you're investing in fundamentally sound companies and funds, unrealized losses shouldn't cause you to panic sell. Understand that volatility will never go away, and focus on your long-term financial goals.