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Thanks to the ongoing stock market correction, a wide range of cheap stocks are available to buy today.
Equity volatility as inflation and interest rates rise introduce new risks that investors need to address. However, in the long term, the performance of undervalued companies could be spectacular for patient people.
And with the right buying strategy, the risks of investing during volatility can be partially mitigated.
Buying during a stock market correction
Every week it seems like a new stock market underperformance record is being broken. But underneath all this chaos, inflation has actually started to reverse. UK inflation for August fell for the first time since this debacle began.
Assuming this trend can continue, we may be nearing the end of the stock market’s downside correction, even if stock prices don’t reflect it yet. In other words, the window of opportunity to pick up cheap UK stocks may be closing.
Investing in businesses when prices are apparently in free fall is an understandably scary prospect. But as every other correction or decline in the past has shown, fortunes are made in bear markets. Fortunately, there is a relatively simple buying strategy called Pound-Cost-Averaging that helps mitigate the risk of stock price freefall.
Instead of trying to time the minimum time of the correction, which is almost impossible, I can divide my excess capital into smaller parts. Then, every week or month, I’ll pump my money into the businesses that I think are most undervalued.
What does this accomplish? With so much volatility plaguing the markets, the potential for significant price declines, even on excellent deals, is high. You might only invest in seemingly cheap stocks today only to see them get even cheaper next week.
Splitting my capital into smaller pieces allows me to buy more shares in what I believe to be excellent businesses at potentially lower prices. This lowers the average cost of my portfolio position, allowing for potentially higher returns if and when the stock price eventually recovers.
Not everything recovers in the long run
From a general perspective, the stock market has a 100% success rate in recovering from even the most disastrous financial catastrophes. But when it comes to individual stocks, things get murky.
As a long-term investor, the current economic climate is ultimately a short-term issue. And according to the existing consensus, it could be solved in the next two years. But that doesn’t mean it’s not having a tangible impact on businesses today.
Higher living costs have already caused consumer spending to fall off a cliff, making it quite difficult for most industries to grow. Meanwhile, higher interest rates raise the cost of servicing credit obligations, increasing pressure on leveraged companies. And with many companies taking on debt to survive the pandemic in 2020, the rate of insolvencies is rising.
Consequently, there are undoubtedly many cheap stocks today that are being discounted for good reason. That is why, before making any investment decision, it is essential to understand the financial state of the underlying business.
Let’s assume that cash flow has been compromised or margins are falling rapidly. In that case, there is a higher chance that you may be looking at a value trap rather than a buying opportunity.