So many people presume they will know what to do when a correction comes. I wish it were that easy.

Hindsight is 20/20, and everything looks obvious after the fact. But I can tell you from first-hand experience. It’s nearly impossible to swing for the fences and buy up the significant dips when everything is burning around you.

Take the pandemic as an example. In March 2020, companies that I held, and had positive conviction in, fell 50%. It’s easy to look back now and see that these were buying opportunities, but committing capital to a company as it craters is testing for even the most unwavering Stalwart.

The narrative upon which you initially invested has now completely changed.

Nothing is obvious.

When the economy comes to a standstill, the world grounds to a halt, commodity markets fall apart, policymakers are changing the rules, and the government needs to step in to shore up the Fixed Income market. Will you be able to set aside emotion and dive in headfirst?

They say you learn from experience, and for me, my lack of a clear analytical checklist left me in a state of decision paralysis. Lesson learned.

Create your Checklist

Most of us mere mortals can’t separate logic from emotion in the heat of the moment, so make sure you set out some rules to guide you through those clouded moments.

You can think of your emotional state and the ability to make good decisions as sitting on opposite sides of a seesaw. If your state of emotional arousal is high, your capacity to decide well is low. A checklist helps take out the emotion and moves you toward a proper choice. It also keeps you from succumbing to decision paralysis.

This checklist will be different for everyone, but here are some examples.

Does the company still hold a competitive advantage?
Is this correction macro-led or idiosyncratic? - is this just contagion effects from a market-wide sell-off, or is this a company-specific correction?
Has the growth outlook for the company dramatically changed?
Is this an earnings or non-earnings event? For example, did the stock fall off the back of a disappointing quarterly earnings call, or is this a non-earnings-related correction? There will always be some added volatility during each earnings season, so it is important to make the distinction.
Analyze the value indicators of the company - Is the company competitively priced relative to others in its sector? This is done by measuring the key metrics (P/E, P/S, FCF, etc.) against the company’s competitors.
Analyze the momentum indicators for the company – 200-day moving average, MACD, RSI, Support and Resistance levels. These technical indicators will help you establish when the stock is overbought or oversold.
Analyze the quality indicators for the company - Compare Free cash flow metrics, Cash Flow Return on Equity figures, ROIC, Gross Profits and EPS stability relative to competitors
If these metrics remain strong, so too should your conviction.

No Shortcuts

Some of these terms may be new to you, but you need to know them if you are looking to be a successful stock picker over the long term. Buying stocks simply because they have fallen and you expect them to mean revert is a recipe for disaster.

More than 40% of all companies that were ever in the Russell 3000 Index experienced a “catastrophic stock price loss”, which we define as a 70% decline from peak levels which is not recovered.

Don’t just assume these stocks will come back. Many of them don’t. You have a much greater probability of picking a mega loser than a mega winner.

“While the most successful companies generated massive wealth over the long run, only around 10% of all stocks since 1980 met the definition of “mega winners”.

It’s perfectly ok to be a contrarian, but be a well-informed contrarian, don’t just blindly follow the stock down. The odds are not in your favour.

With the new year just around the corner, take some time to set out your investment plan and checklist for the coming year. Fortune favours the prepared.

As always, you can find more investing information at theislandinvestor.com