Corrections are part of the natural order of markets.
Markets move erratically because they’re driven by millions of people pushing, pulling, and reacting. While there can be wisdom in the crowd over the long term, in the short term, markets fluctuate based on emotion, on day traders trying to earn a quick buck, and on fleeting news with little real economic impact.
Instead of fearing corrections, professional investors know how to ride the rhythms of the market and make money on them. Most of all, they know that corrections and the occasional bear market are no reason to avoid investing in stocks.
Standing on the Sidelines Is Worse Than Bad Timing
Letting fear keep you out of the stock market is far more expensive than the risk of losses or bad timing.
A Charles Schwab study analyzed how S&P 500 investors would have performed if they invested $2,000 once each year on the best day, the worst day, or the first day of the year. It compared these imaginary returns over 20-year periods dating back to 1926, then added the control of not investing in stocks at all, but instead keeping money in U.S. Treasury bills.
In other words, if you were the luckiest – or the unluckiest – stock investor alive, how would your stocks perform compared with someone who didn’t invest in stocks at all?
Over the average 20-year period, a person who invested $2,000 on the first day each year finished with $167,422. An investor who timed the market perfectly, buying on the lowest-priced day each year, averaged only slightly higher at $180,150. And someone with terrible luck who bought on the worst day each year still ended with an average of $146,743 after 20 years.
But someone too afraid to invest in stocks, who sat on the sidelines and put money in Treasury bills, ended with an average of $65,715 – less than half of what they would have earned in the stock market, even if they were the unluckiest stock investor alive.
Playing it “safe” isn’t so safe after all.
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10 Facts About Stock Market Corrections to Quell Your Fears
If the above study wasn’t enough to ease your fears, consider these 10 facts about stock market corrections and returns to help you sleep soundly at night, even while the rest of the world panics.
The statistics below are based on the S&P 500, an index of large-cap U.S. companies. Historical data on the S&P 500 is widely available to the public; your online brokerage account will let you access it, or you can go to the source at Standard & Poor’s. Similar market patterns appear across market caps, countries, and sectors, so these trends are nearly universal, even if the exact statistics vary slightly.
1. Corrections Happen Frequently, Then They Go Away
A correction is a drop of 10% or more from a recent market high. Since 1950, there have been 36 corrections in the S&P 500. That comes to an average of one correction every 1.9 years.
The market dips, and then the market bounces back. It rises some more, dips again, then turns and starts rising again, ad infinitum. There has never been a correction from which the U.S. stock market didn’t recover.
2. Most Corrections Last Under 4 Months
Of those 36 corrections in the S&P 500, 22 of them lasted four months or less. The average correction lasted longer at 196 days. But the average is skewed by a few particularly nasty bear markets that lasted longer than usual (more on bear markets shortly).
Interestingly, the average correction length seems to be shortening over time. Between 1950 and 1984, 11 of the 22 corrections (50%) took longer than 104 days to recover. The shortest of these was 162 days. Since 1984, only three of the 14 corrections (21%) took longer than 104 days – and two were the infamous dot-com bubble and the Great Recession. That means that four out of five corrections over the last 35 years have been shorter than 3.5 months. That’s hardly something worth panicking about.
3. Corrections May Be Common, But Bear Markets Are Rare
A bear market is a market drop of over 20%. And they don’t happen very often.
Since 1987, there have only been two bear markets: the dot-com bubble and the Great Recession. They are also the only two corrections to last longer than 10 months during that period. That means only around 15% of stock market corrections in that period evolved into full-blown bear markets. Even going back to 1950, only a quarter of corrections turned into bear markets.
Bear markets do happen, but they’re far less common than your garden-variety stock market correction.
4. Volatility Rises During Corrections
When stocks start skidding, volatility jumps through the roof – and not in a linear way.
Volatility spikes exponentially. One reason is that volume skyrockets during corrections, as many investors panic and others see opportunity. Day traders, who thrive on volatility, also pick up the pace of their volume.
But the extra volatility is not caused by higher volume alone. Not only do more shares change hands, but the amount of movement per trade also jumps.
Brett Steenbarger, a professor of psychiatry and behavioral sciences who specializes in coaching hedge fund managers, broke down an example on Forbes showing how volume multiplied by 2.5 times in a 2018 dip, even as movement per trade doubled. Volume multiplied by 2.5, further multiplied by 2 times the movement per trade, equals 5 times the volatility in the market.
What does this mean for investors? First, it means that corrections are a bad time to buy on margin. The last place you want to find yourself is forced to sell at a loss due to a margin call during a volatile correction period. It also means that you can buy discounted shares in fundamentally sound companies that happen to take a beating because the overall market drops in a selling frenzy.
5. Emotional Decisions Lead to Poor Returns
Study after study has shown that twitchy stock investors, who buy and sell reactively rather than buying and holding long-term, underperform the market.
One joint study by the University of California Davis and U.C. Berkeley concluded that investors tend to “trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many … are unduly influenced by media and past experience.” Another study, conducted by the University of Missouri, shows that loss aversion causes people to panic sell when markets dip, leading to losses from selling low.
Corrections happen, and often, but that doesn’t mean you should panic and sell at a loss. Doing so is a good way to lose money.
6. Dividend Stocks Can Weather the Storm in a Correction
A study published in Financial Analysts Journal found that high-dividend stocks showed less volatility, even during corrections. The authors divided stocks into groups based on their dividend yield and found that high-dividend-paying stocks – those with an average dividend yield of 4.3% – had significantly lower volatility than both low-dividend-paying stocks and stocks that paid no dividend.
In fact, stocks that paid no dividend showed the highest volatility of the lot.
The same study found that high-dividend-paying stocks also averaged higher returns over time – an average monthly return of 0.9% compared with 0.77% for stocks that paid no dividends. That defies the conventional wisdom that higher returns require higher risk; the stocks with the lowest risk, as measured by volatility, saw the highest average returns.
One reason for the reduced volatility is that companies that pay dividends tend to be more established, stable companies. But the dividend also provides a “floor” for the stock price; if the price falls, the yield rises, making the stock increasingly attractive to income investors.
7. Corrections Are Less Likely in the Third Year of a Presidential Cycle
Economists argue over the “presidential cycle” theory of stock returns, but the numbers are persuasive. Yardeni Research, Inc. released a study demonstrating that since 1928, the average S&P 500 returns in each year of the presidential cycle are as follows:
- First Year: 5.2%
- Second Year: 4.8%
- Third Year: 12.8%
- Fourth Year: 5.7%
Proponents of the presidential cycle theory explain that investors get jittery leading up to the midterm elections because they don’t like uncertainty of any kind. After the midterm elections, investors who have been hedging on the sidelines start easing their money back into the market because they now have a known quantity in the Oval Office and two years of relative political stability before the next election.
Another group of economists reviewed over two centuries of stock market data to measure the impact of midterm elections and had similar findings: Uncertainty causes poor stock performance leading up to the midterm elections, then the stock market performs exceptionally well in the following year.
8. Corrections Recover Quickly; Bear Markets Don’t
Remember, the average correction takes under four months to reach bottom, then it turns around and recovers.
Reporting on an analysis by Goldman Sachs, CNBC showed that the average correction in the S&P 500 took around four months to reach its pre-correction peak – roughly the same amount of time to recover as the initial decline took.
But that’s not what happens with bear markets. When the S&P 500 drops by more than 20%, bear markets historically have averaged 13 months before reaching bottom. Rather than taking 13 months to recover – the same 1-to-1 ratio garden-variety corrections exhibit – bear markets take an average of 22 months to recover.
When investors get truly spooked, it seems they’re not as quick to re-enter the market.
9. No One Can Predict When a Correction Will Hit
Sure, corrections happen every 1.9 years on average, but the exact timing could be anywhere from a few months to many years apart.
And despite what the pundits will have you believe, no one has “cracked the code” or “found the ultimate technical indicator” that reliably predicts corrections. When you read a news report about some analyst who predicted the last correction shouting doom and gloom that the next correction is nigh, bear in mind that they probably just got lucky the last time around.
At any given moment, there are plenty of analysts predicting the next correction. Just because they luck into calling one doesn’t mean they have the magic formula no one else has figured out yet.
There are some economic indicators that show when stocks are overbought or when volatility surges, but just because stocks are overpriced, that doesn’t mean the crash will happen now. They may continue to grow even more overpriced for years to come before crashing back down to earth.
For a quick overview of a few of the most common indicators that can signal a correction, try investment advisor’s Duncan Rolph’s explanation on Forbes of what they are, why they’re relevant, and why you still can’t use them as a crystal ball for your investing decisions.
10. When Stock Storms End, the Sun Shines Brighter Than Usual
In the year after the market low point in March of 2009, the S&P 500 grew by 69%. That isn’t an anomaly. Following the three previous bear markets, the index averaged 32% growth in the following year.
The best returns often happen in the first month or two after the market hits rock bottom. After the dot-com bubble collapse, the first month of recovery yielded 15%. The first month after the S&P 500 hit bottom in 2009 saw growth of 27%.
That’s the thing about standing on the sidelines: By the time you “wait and see” and are confident that the recovery is underway, you’ve already missed much of it.
Corrections are not the greatest risk to your money; the fear of corrections is. Stop worrying about corrections and instead follow these fundamentals of stock market investing. Forget about trying to time the market, and try dollar cost averaging instead.
As a parting statistic, consider that in the 20 years between 1996 and 2015, the average annual return on the S&P 500 was 8.2%. But if you tried to be clever, to wait for recoveries before investing and time the market, and you missed the 10 best days in the stock market during that time? Your annual returns would have dropped from 8.2% to 4.5% – all from missing 10 days out of 7,300.
Investing isn’t about being clever. It’s about being patient and disciplined and, of course, not letting fear rattle you even when everyone else is panicking.
What have your experiences been with stock market corrections?