Investing in the stock market can be an extremely lucrative financial decision if you play your cards right—but in order to do that, you have to know a thing or two about how the stock market works. There are many things that can impact the trajectory of your stocks—industry changes, market volatility, and company financial changes—to name a few. But there’s one market-level change that could have a serious impact on your shares across any number of industries. This is called a stock market correction. If you’ve already stopped to ask yourself “what’s a stock market correction?”, never fear.
In this post, we’ll be answering the following questions and showing you how to prepare for a market correction. Use the links below to instantly view the answer to your question, or read all the way through to learn some of the top considerations you need to know about stock corrections.
- What is a Stock Market Correction?
- What Causes Stock Market Corrections?
- Steps to Prepare for a Stock Market Correction
- Final Notes
What is a Stock Market Correction?
A stock market correction is when the value of securities on the stock market decline by 10% or more when compared to their last peak in price. If stock prices continue to fall and dip 20% or lower, investors would consider this bear market territory, which is separate from a stock market correction. In order to better understand stock market corrections and why they happen, let’s discuss some stock market terminology in greater detail.
Bull market definition: A bull market is considered a positive market condition for investors. Bull markets are characterized by a 20% increase in stock prices.
Bear market definition: A bear market is essentially the opposite of a bull market and is when the prices of securities fall 20% or more from their most recent high.
So, what’s the difference between a stock market correction and a bear market?
In addition to the percentage of change in which stocks increase or decrease in value, there are a few other factors that separate market corrections and bear markets.
- Market corrections are when securities lose 10% or more of their value
- A bear market is when securities lose 20% or more of their value
- Stock market corrections tend to last less time than bear markets
- Bear markets don’t happen as frequently as stock market corrections
- Stock market corrections are typically regarded as less threatening than bear markets
- A stock market correction that persists could lead to a bear market
Barron’s Financial and Investment News provides this analogy: You can think of a market correction like a cold—it’s temporary, normal, and can be considered a healthy part of a bull market. A bear market is compared to pneumonia—it’s a more serious downturn that can be prolonged over time and it’s not so common as market corrections, which generally happen every few years. Bear markets also tend to trigger more response from the government and other organizations in order to push the market back into bull territory.
Now that you know what stock market corrections are, let’s discuss why they happen.
What Causes Stock Market Corrections?
Like most things in the economic realm, there are many different factors that play into changes in the stock market. A political event, changes to tax and economic policy, and adjustments in investor attitudes can all contribute to a stock market shift—whether it’s for the better, or worse.
There’s no definitive answer to why stock market corrections occur because they’re simply a natural part of the stock market’s vitality. Plus, the unpredictability of the stock market is kind of the name of the game, isn’t it?
To summarize, stock market corrections can be caused by any number of things from hikes in unemployment to retail sales and global economic issues. If you’re trying to predict the next market correction, you may be out of luck. It’s nearly impossible to predict when a stock market correction might occur and as we’ll discuss when we talk about how to prepare for a market correction, it might not be worth your time to try and anticipate what the market will and won’t do. Instead, investors can look at historical trends and take steps to protect their portfolio in case a correction occurs.
How long do stock market corrections last?
According to Investopedia, stock market corrections can last anywhere from a day to a few weeks or months, but the average stock market correction lasts between 3 and 4 months. Based on data collected from the S&P 500, CNBC and Goldman Sachs estimated that the stock market loses 13% in a four-month market correction if it does not turn into a bear market.
Do stock market corrections happen often?
Yes. In fact, U.S. markets experienced 37 corrections from 1980 and 2018, ten of which plummeted to the bear market category. The other market corrections transitioned back into bull markets.
Are there any advantages to stock market corrections?
Depending on how you invest and what you invest in, there can be both advantages and drawbacks to stock market corrections:
- Creates an opportunity for investors to buy into stocks that are typically high-value
- Can reduce the impact of over-inflated markets
- There are ways to prepare for stock market corrections to mitigate loss
- Short-term traders such as day traders can be disproportionately impacted (read our guide to day trading basics to learn more about the risks and rewards of this trading style)
- If prolonged, it can trigger a bear market
- Can cause investors to panic and liquidate too many securities
Should you invest when the stock market is in a correction?
Market corrections impact different types of stocks in varying levels of severity. According to Investopedia, small-cap stocks in volatile industries (like science and technology) typically take harder hits in market corrections; whereas consumer staple stocks (like food, beverage, and household goods) are often considered more stable in a market correction.
Some investors may choose to take advantage of low offering prices in stable and volatile sectors with the intention to profit on securities when the market recovers. On the other hand, some consumers might prioritize saving vs. investing when a market is in flux.
Ultimately, investing in the stock market provides some level of risk no matter when or how you do it. But understanding how the market works and learning how to prepare for a market correction can help you mitigate this risk.
Steps to Prepare for a Stock Market Correction
Although we can’t predict stock market corrections with certainty, there are ways investors can prepare their investment portfolios to fair better in the event of a market correction. Keep in mind, your financial needs and investment strategies are all unique to your situation. Use these steps as suggestions rather than rules to protect your securities in a market correction.
1) Identify your investment goals
Whether or not the stock market is in a correction, a bear market, or a bull market, having a plan for your investments is a good idea. Simply having an idea of which investments you want to hold in the long or short-term can bring you some assurance so that you’re not tempted to react to market changes with emotion rather than logic.
2) Evaluate your investment profile’s diversity
As we mentioned previously, stock market corrections impact investors differently depending on their investment styles and strategy. If you’re only investing in short-term securities, you may feel the effects of a stock market correction more seriously than if you had a diverse profile of assets. Theoretically, if you had a few long-term investments in the mix, your securities would have time to recover from a correction, so long as the market shifts toward an upward trend.
In addition, investors may want to diversify the risk of their assets so that they don’t have a fleet of high-risk investments being threatened by a market correction.
3) Take action where you can
Since stock market corrections are so unpredictable, there’s a high-risk that those with securities will experience some amount of loss during a market’s correction period. There’s just not a good way to time the market to avoid it. But even if you can’t avoid losing value altogether, you can take steps to mitigate your losses.
A stop-loss order is basically a rule that an investor organizes with their broker. This rule determines when an asset should be sold and at what price. By implementing these guidelines, an investor can limit how much financial loss they experience.
4) Keep a close eye on the market
If you look at just about any guide investing for beginners, you’ll likely see something about staying informed on market conditions. Making sure you’re up to date on market indicators can help you tailor your plan ahead of time so that you can handle market changes more gracefully.
In addition to the market’s status, you should also use an investment tracker to evaluate your stock’s performance and glean insight on historical data.
5) Don’t take market predictions too seriously
At this point in the article, you should know that the stock market is unpredictable, and therefore, stock market corrections are unpredictable, too. Many investors and “experts” will try to speculate on market conditions, but investors may want to take these predictions with a grain of salt.
One of the main threats market corrections pose is the panic felt by investors. Oftentimes, investors will sell too many of their assets out of fear, rather than using logic to evaluate their overall investment strategy. Before making any major investment or financial decisions, be sure to consider the long-term impact of your decision.
- A stock market correction is a market condition that’s categorized by a 10% decrease in stock prices. Market corrections happen fairly regularly, but they don’t tend to last long.
- Even though financial news organizations and investor experts may claim to know when they’re coming, stock market corrections are nearly impossible to predict.
- Investors may experience some loss in a market correction, but there are some strategies they can employ in order to prepare their profile for market changes.
- When reacting to stock market changes, investors should consider their financial standing and investment goals to choose the direction that makes the most sense for them.