What Is a Market Correction and How You Can Weather One
September 23, 2022
What Is a Market Correction and How You Can Weather One
September 23, 2022
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The reality is that no market goes straight up without pulling back or correcting itself. The market can be an individual stock, an index such as the S&P 500 or Dow Jones Industrial Average, or a bond. It doesn’t matter the instrument; at some point, it will pull back—and that’s completely normal and relatively common. Since World War II, the S&P 500 alone has corrected 27 times.1
Understanding corrections—what they mean and how to weather them—can help you protect your assets and wealth and better manage your expectations. This article covers what market corrections are, why they occur, and what steps you can take to ensure your investments—whether it be your retirement account or individual investment portfolio—are strategized properly.
What Is a Market Correction?
According to Schwab, “Most people consider a correction to have occurred when a major stock index, such as the S&P 500® index or Dow Jones Industrial Average, declines by more than 10% (but less than 20%) from its most recent peak. It’s called a correction because historically, the drop often “corrects” and returns prices to their longer-term trend.”
Market corrections are generally short-lived—lasting a few weeks to a few months. On the other hand, a bear market is a deeper and longer decline—beginning when stock prices broadly decline by at least 20% over a minimum of two months, causing an economic downturn. Employees may lose their jobs, causing unemployment levels to rise, and gross domestic product (GDP) and stock market prices will decline. Bear markets last 9.6 months (Hartford Funds) to 15 months (Schwab) on average with an average loss in stock value of 36%. Market corrections can turn into bear markets, but this is a less common result. According to Forbes, “out of the 33 instances of corrections that occurred from 1971 to 2021, seven turned into a bear market, while 26 resolved higher. In other words, there has been a roughly 1 in 5 chance a correction turns to a bear market in the past.”
Why Markets Correct
Fundamentally, a market corrects because there are more sellers than buyers—“investors are more motivated to sell than to buy” (Nerdwallet). If you were paying attention in your economics class, it’s the classic supply meets demand scenario. There is simply more supply than demand. Now, the real question is: Why?
There may be more sellers than buyers because of any or some combination of the following: some catastrophe or other external (or outsized) event like the coronavirus pandemic, a trade war with China, the threat of an actual war; inflation; a slowing or shrinking economy; a particular industry/sector implodes (e.g., mortgage companies and the housing crash of 2008); or the market being “overheated,” meaning stock valuations are just too high. Often, fear and emotions can drive market corrections.
The moral of the story is that markets will correct. They have to pull back to find more buyers. Think of it like a car. A car can’t go forever at top speed. At some point, it must slow down or even stop—whether to refuel, pick up more passengers, or get repaired. Just like a moving car, a market at some point must slow down to refuel, i.e., find more buyers. The buying phase is what sends prices soaring.
What To Do During a Market Correction
Unless you are a short-term investor or highly leveraged, it’s probably best that to hold tight during a market correction—sometimes, not doing anything is the best course of action. Most market corrections are short-lived. According to CNBC, “corrections [resulting] in a 13% decline and take about four months to recover to prior levels, on average.” Don’t panic and sell when the market is in a correction, at least not without doing your due diligence and consulting with your financial professional.
Several other strategies can help you weather market corrections:
- Understand the mechanics of market corrections and what’s causing this specific one
- Build a diversified portfolio that aligns with your risk tolerance and rebalance it regularly
- Have an emergency fund in cash to help you avoid dipping into your investments when you need money
- Re-check your risk tolerance each year with your financial professional – people tend to get more risk-averse as they get older, as their investing horizon shortens, and they approach or enter retirement. Schwab states “If you’ve recently retired and begun to withdraw from your portfolio, you also should be aware that poor returns in the early years of retirementcan have a very negative effect on a portfolio; consider taking steps to avoid selling assets in a down market, such as reducing your planned withdrawals or postponing large expenses.”
You may be wondering: What if the market drops beyond a correction and turns into a bear market? If you find yourself in a bear market, Schwab.com states that “since 1966, the average bear market has lasted roughly 15 months, far shorter than the average bull market. And they often end as abruptly as they began, with a quick rebound that is very difficult to predict—a case in point is the S&P 500’s pandemic-fueled bear market in early 2020, which lasted a mere 33 days from the previous high on February 19 to the trough on March 23.” So, if you’re a long-term investor, it doesn’t matter if you find yourself in a market correction or a bear market, the market will eventually bounce back, and you can recover your losses. You may even gain if you hold onto your positions past where you bought them.
The Bottom Line
Market corrections can’t be avoided—they’re part of the deal when investing. But there are ways to hedge your losses during these corrections. If you’re a long-term investor, meaning your investment horizon is longer than a few years and you’re willing to accept a certain amount of risk or can afford to be patient and have capital tied up for a longer amount of time, a market correction is nothing to fear. Even if you find yourself in a bear market, your investment can recover if you don’t panic and sell.
1Hartford Funds. 10 Things You Should Know About Bear Markets. https://www.hartfordfunds.com/practice-management/client-conversations/managing-volatility/bear-markets.html
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Frank, Thomas. (February 27, 2020). Here’s how long stock market corrections last and how bad they can get. CNBC. https://www.cnbc.com/2020/02/27/heres-how-long-stock-market-corrections-last-and-how-bad-they-can-get.html
Hartford Funds. (n.d.) 10 Things You Should Know About Bear Markets. https://www.hartfordfunds.com/practice-management/client-conversations/managing-volatility/bear-markets.html
Marquit, Miranda. (July 28, 2022). What Is a Market Correction? Forbes Advisor. https://www.forbes.com/advisor/investing/what-is-market-correction/#:~:text=A%20correction%20is%20a%20sustained,of%20your%20favorite%20tech%20company
Maverick, J.B. (August 16, 2022). S&P 500 Average Return. Investopedia. https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp#:~:text=Key%20Takeaways,through%20the%20end%20of%202021
Royal James. (June 14, 2022). What Is a Stock Market Correction? https://www.nerdwallet.com/article/investing/what-is-a-stock-market-correction-and-what-happens-in-a-crash#:~:text=Why%20stock%20market%20corrections%20happen,explain%20why%20investors%20are%20selling
Schwab.com. (January 25, 2022). Market Correction: What Does It Mean? Charles Schwab. https://www.schwab.com/learn/story/market-correction-what-does-it-mean#:~:text=The%20general%20definition%20of%20a,no%20guarantee%20of%20future%20results
Webster, Ian. (n.d.). Stock market returns since 1970. https://www.officialdata.org/us/stocks/s-p-500/1970