What is a stock market correction and how do I handle one?
People look to the stock market as a way to build and protect wealth, but experienced investors know it doesn’t always work out that way. The market moves through a series of peaks and valleys, often leading to overvaluations or undervaluations.
When a long-term bull market takes place, investors know that a dreaded downturn on Wall Street is likely ahead.
These drawdowns, or market corrections, are periods when stock valuations fall. They tend to cause some investors to panic, but there’s no need to be alarmed. These occasional declines are perfectly normal, and most consider them necessary in a healthy U.S. stock market.
Here’s everything you need to know about market corrections.
What Is a Stock Market Correction?
A correction is a downward market trend characterized by the value of a financial asset falling at least 10% from its most recent peak.
For example, imagine stock ABC was trading at a peak of $100 per share 45 days ago. Today, the stock is trading at $89 per share, down $11 or 11% from recent highs. Since the decline is greater than 10%, the move would be considered a correction.
These market declines are often riddled with volatility as investors race to sell, hoping to protect themselves from further financial pain.
However, as you’ll learn below, a sudden drop in stock prices from recent highs isn’t always a reason to sell. In fact, corrections are often the best time to buy more shares of your favorite stocks, practicing dollar-cost averaging and increasing your overall return potential.
Here are a few important facts about corrections:
There Are Different Levels of Stock Market Corrections
First and foremost, market corrections take place on varying levels:
Like in the example above, corrections often happen on individual stocks. They can be spurred by bad news like missed earnings or revenue expectations, or they can come completely out of the blue as a group of investors decides it’s time to take a profit. These corrections only tend to affect a single stock.
Some corrections wreak havoc on entire sectors, sending nearly every stock in an industry down a slide. For example, sudden shocks to the price of oil might put the oil and gas sector into a correction, or new legislation targeting drug prices might send the pharmaceutical sector into a slump.
Some events can lead entire financial markets in a specific region on a spiral downward. For example, when tariffs were placed on Chinese goods entering the United States, Chinese stocks took a dive, resulting in a regional correction.
Finally, corrections can happen across the global market. During a stock market correction, the entire market drops. These events are characterized by simultaneous declines of 10% or more throughout major market indexes around the globe.
Corrections Are Generally Short-Lived
While some market corrections lead to long-lasting bear markets, the vast majority of corrections are actually short-term sell-offs. In fact, only 10 out of the past 37 corrections from 1980 to 2018 resulted in bear markets, with the rest turning out to be short-term blips.
In general, corrections last between three and four months. Once the event is over, the market generally rebounds quickly, resulting in tremendous earnings potential. So, it’s important not to panic when these events take place; keeping a level head and paying attention to market conditions will likely open the door to several profitable opportunities.
A Correction Isn’t the Same as a Bear Market
Both corrections and bear markets are characterized by stock market crashes. However, there are a few important differences between the two:
- Percentage Declines. Bear markets are generally characterized by declines of 20% or more from recent peak values rather than 10% declines.
- Term. When the bears take hold of a sector, region, or the whole market, they tend to maintain control for some time. According to Hartford Funds, the average bear market lasts 9.6 months, which is substantially longer than the three to four months the average correction takes to subside.
- Cause. Corrections can take place out of the blue when the investing masses decide it’s time to take profit. However, bear markets are generally more meaningful. These long-standing declines are usually signs of concerning economic conditions, geopolitical conditions, or a mix of the two.
Corrections Happen Often
As mentioned above, 37 corrections took place from 1980 to 2018, working out to slightly less than one per year on average. That stands as evidence that you shouldn’t panic when it happens.
While the talking heads on financial media will make a big deal out of any correction that takes place, level heads prevail in the stock market.
Examples of Corrections
One of the best ways to get an understanding of the nature of stock market corrections is to look at a few examples from history.
One of the most recent market-wide corrections was caused by the coronavirus pandemic in 2020. As the virus spread, hair salons, movie theaters, amusement parks, and shopping malls were considered nonessential and forced to shut down for months. This led to widespread job loss, corporate bankruptcies, and reduced consumer spending.
As a result, the market started to tank.
Soon, the correction caused by the pandemic became an all-out bear market, leading the S&P 500 index, Dow Jones Industrial Average, and the Nasdaq all down by more than 30%. It took 10 months for all three indexes to make a full recovery.
Another example occurred in February 2018, when the Dow Jones Industrial Average and the S&P 500 index fell by more than 10% each. While the correction was prompted by inflation-related concerns, the profit-taking proved to be overblown in the long run. By mid-March 2018, prices began to rise, eventually making a full recovery.
What Corrections Tell You
Market corrections aren’t always as informative as you might think. They can be a sign of healthy market and economic conditions as valuations balance themselves out, acting as a perfectly normal part of the financial system.
For example, if a correction happens out of the blue at a time when economic growth is at its peak, corporations are experiencing growth in profitability, and geopolitical conditions are stable, the move is likely nothing more than investors taking profits, and it will soon be over.
On the other hand, when coupled with concerning fundamental data, corrections can be signs of tough times to come.
For example, if recent economic reports show slowing new home sales, increasing unemployment insurance claims, and declining consumer spending, and stocks slide by 10% or more, the move could be a sign that an economic recession and all-out bear market is on the horizon.
What to Do if a Stock Market Correction Takes Place
Although it may come as a surprise, many long-term investors do nothing at all when market downturns set in. These investors know that the vast majority of corrections won’t last long, and they avoid knee-jerk reactions when it happens. Riding out corrections is the favored approach of buy-and-hold investors, especially those with a long-term outlook.
On the other hand, some seasoned active investors take steps in order to make the declines work to their advantage. Here’s how:
If you’ve been following a solid investment strategy, your asset allocation was thoughtfully chosen to provide diversification.
Unfortunately, over time, your allocation will fall out of balance as some assets move at faster rates and in different directions than others. When imbalance happens, it can leave you either overexposed to risk or underexposed to opportunity.
With the market edging down, it’s crucial to make sure your allocation isn’t out of balance and the protections you’ve put in place are able to work to your advantage. Now is the time to rebalance your investment portfolio.
2. Assess the Correction
Next, you’ll want to determine what type of correction you’re seeing and whether the move is likely to continue into a bear market. Ask yourself the following questions:
- How Widespread Is the Correction? Are you noticing the move on a single stock or single index? Take time to look around and see if it’s more widespread. Look into what the Dow Jones Industrial Average, Nasdaq composite index, and S&P 500 index are doing. If they’re all falling at a similar rate, the correction is a widespread one.
- Is There a Clear Cause? Corrections can come out of nowhere with no rhyme or reason, or they may be the result of deep underlying issues. The only way to find out is to do a bit of research.
- How Deep Is the Cause? Did the U.S. Federal Reserve raise interest rates by a quarter of a percent? If so, although the move may slow lending slightly, it’s a sign that the U.S. economy is doing well, and the market will likely recover quickly. On the other hand, if war was just declared or jobs reports have shown months-long declines in hiring, there may be cause for long-term concern.
3. Act On What You’ve Learned
There are several different actions you could take based on your answers to the questions above, but they’ll all boil down to one of the following:
If it’s a Single Stock or Sector Correction With No Apparent Cause
If the move is in a single stock or sector, and there’s no clear rhyme or reason to it, you’re in luck — you’ve found a buying opportunity.
Traders take profits all the time, and this profit-taking can lead to painful, short-term declines. Although there’s no telling where the bottom will be, now is the time to strategically buy more shares in a company you like. Here are a few tips for doing so:
- Set the Floor. If the sell-off has no rhyme or reason, it’s likely a technical move in which traders are taking profits. This means that there will likely be a clear point of support. Use technical analysis to find the support level.
- Buy Even Blocks of Shares. As the stock continues to fall to support, make consistent, equal purchases of blocks of shares. This process of dollar-cost averaging ensures you don’t lose too much with a large purchase before further declines or miss out on opportunities when the rebound happens. As the stock falls, your average cost per share will fall as well. When the rebound happens, that reduced average cost means larger gains.
- Set Stop-Loss Orders. Set stop-loss or stop-limit orders just below the support level. If the stock falls below this point, there may be a significant underlying reason for the declines. It’s time to exit the position and reassess the situation.
If it’s a Single Stock With a Short-Term Cause
In some cases, there will be good reasons for a single stock taking a dive, but those reasons will only lead to short-term movement.
For example, a company may miss earnings or revenue expectations in a single quarter, leading to fear among investors. In this case, the company’s stock will likely fall, but if the company is solid, it will make up the losses and then some in the long run.
If this is the case, consider using the dollar-cost averaging method described above to gain further exposure to the rebound.
If it’s a Single Stock With a Serious Problem
If the correction takes place in a single stock and the reason is both clear and long term, it’s time to sell and accept your losses.
For example, imagine a biotech company you’ve invested in has been working to find the cure for a devastating ailment. Things looked great. However, the FDA rejected the drug, and the company decided it’s going to cut its losses and go back to the drawing board. At this point, the stock’s losses are likely to continue for some time.
In this case, it’s best to cut your losses and look for a more promising opportunity elsewhere.
If the Entire Market Is Falling
If you’re looking at a market-wide correction, there are a few things to consider. In the majority of cases, if the entire market is falling, there’s a reason, regardless of how clear or unclear that reason may be.
One of the most common reasons for market-wide corrections is high valuations. Movement in the market takes place through a series of ebbs and flows. However, when the market flows up too fast without enough ebbs in between, overvaluations happen, and investors begin to take profits.
These are generally short-term moves and nothing to be concerned about. As a result, outside of buying in on undervalued opportunities as prices fall, there’s not much action that needs to be taken.
On the other hand, corrections can be signs of deep economic or geopolitical concerns. For example, if job growth in the U.S. seems to be plateauing, home sales are slowing, and unemployment lines are growing during a market correction, all these signs together point to a potential economic recession, which could cause the correction to turn into a long-term bear market.
Even in this case, it’s important not to panic. After all, panicking leads to poor decision making.
Instead, consider making adjustments to your asset allocation to reduce your overall risk. To do so, move a portion of your money out of stocks and into fixed-income securities and other safe-haven assets.
After doing so, keep a close eye on economic data. When the economy begins to improve, it’s time to go shopping for discounts in the stock market. At this point, long-term declines will have led the valuations of many quality companies into the dumps, which is great news for buyers. Buying in at these lows will often lead to jaw-dropping profits.
4. Consider Speaking to a Financial Advisor
If the market’s experiencing declines, and you’re not sure what to do, one of the best courses of action is to speak to a professional.
Sure, it may cost a few hundred dollars to get a financial advisor’s ear for an hour, but those few hundred dollars could save you thousands — or, even better, help you turn a profit in a down market.
When you have a leak, you call a roofer, even though you know that will cost you more money than doing the research and fixing the roof yourself. There’s no reason to be ashamed to call a financial pro when you have questions about your money and activities in the market.
Pros and Cons of Market Corrections
Although corrections may be concerning at first glance, they’re not all doom and gloom. In fact, there are several benefits to corrections happening as well. Here are the pros and cons of these moves:
Market Correction Pros
1. Discounted Buying Opportunities
The basic concept of making money in the stock market is the act of buying low and selling high. If you’re looking for a strong entry point, there are few better than in the midst of a correction. During these times, stocks are undervalued, offering discounted opportunities to get in on future gains.
2. Market Health
Financial markets are complex systems with multiple moving parts, and for those systems to work properly, there have to be checks and balances. Corrections help to keep the market balanced, which is necessary for a healthy system overall. An occasional round of profit-taking helps to keep euphoria in check.
3. Set the Stage for Bull Markets
A far smaller portion of corrections become bear markets than are followed by bull markets. Statistically, these moves are more often than not signs of a bull market on the horizon.
Market Correction Cons
Unfortunately, market corrections come with some drawbacks, the most important being:
1. Retail Investor Panic
The biggest victims of corrections are often inexperienced retail investors who panic and sell when stocks fall. While the retail crowd sells for a loss, savvy investors — often institutional investors or experienced traders — are picking up their shares and enjoying the gains the average investor would have had if they’d simply kept a level head.
2. Can Be Signs of Bear Markets
Although a market correction is more likely to be followed by a bull market than a bear market, there are times when bear markets do set in. If economic conditions are troubling, a correction can be a signal of something even worse ahead. It’s important to understand the reason for the correction and determine whether a long-term bear market is likely before deciding how to react.
3. Short-Term Financial Pain
Finally, stock market corrections aren’t significant points of pain for everyone. Although nobody likes to see short-term losses, for some investors, the moves can come with significant financial concern.
This is particularly the case for investors with a short time horizon, like retirees. Investors who are dependent on the income generated through their portfolios often have to withdraw money to survive during market corrections. Unfortunately, these investors don’t always have the option of waiting for the correction to end and may be forced to realize significant losses.
All told, corrections aren’t quite as scary as they’re cracked up to be. Sure, losses can and often do happen during these downward moves. However, they’re important cycles that help to keep the overall financial machine healthy.
Not to mention, savvy investors can make corrections work to their advantage by strategically buying undervalued stocks for a discount to take advantage of the gains that are likely to follow.
No matter what your plan is during a market correction, it’s important not to panic. Level heads make educated decisions, and educated decisions usually equate to profits in the stock market.