As an investor, watching the stock market drop can be scary. After months or years of steady growth, you can lose a significant portion of your gains and it can feel as if your financial future is slipping away.
However, these downturns – known as stock market corrections – are often short-lived. They’re also an essential part of how the market works.
Today, we’ll cover how corrections work, why the stock market needs them, and what you can do to weather a stock market correction.
What is a Stock Market Correction?
A stock market correction happens when the market drops more than 10% from its most recent 52-week high. This usually happens over the course of a few weeks or a few months, although it can also happen in just a few days.
Importantly, a correction can be measured in a single stock or in a market index like the S&P 500. Usually, when investors talk about a ‘stock market correction,’ they’re referring to a correction that’s observed in the S&P 500, Dow Jones Industrial Average, or the NASDAQ 100. It might not be a huge deal to investors if a single stock drops 10%, but everyone will notice if hundreds of major companies lose 10% or more of their value.
Corrections are extremely hard to predict, and there’s not always a clear cause when they do happen. Sometimes a correction is spurred by a bad economic report, but other times its simply because investors’ enthusiasm for ultra-high stock valuations is wearing off.
On average, stock market corrections happen about once per year. Most last only around 3 months, although severe corrections can lead to a long-term bear market (a drop of 20% or more).
Why Does the Market Need Corrections?
While it might not feel very good to watch your portfolio lose value, corrections are critical to the proper functioning of the stock market.
Without corrections, the market would go up and up without almost no check on whether stock prices were really reflective of companies’ fundamental value. In fact, the very threat of a correction helps to keep the stock market in check. Investors will be much more willing to pour money into overvalued companies as long as they know that a correction could happen at any time.
When a correction happens, investors have a chance to re-evaluate what companies are really worth. They can trim valuations that are unsustainable, and find opportunities to invest more in companies that are undervalued by the stock market.
Corrections vs. Crashes
It’s important to understand the difference between a correction, which is healthy for the stock market, and a crash, which isn’t so healthy. A correction takes place over a few days, and more often over weeks or months. In a crash, the market loses more than 10% of its value in a single day of trading.
Crashes aren’t considered healthy because they usually involve panic selling. Investors aren’t carefully considering whether or not a company is overvalued. Instead, they’re just trying to get money out of the market as quickly as possible.
Still, like corrections, not all crashes have bad long-term effects. In many cases, the market stabilizes in the days after a crash and investors have a chance to buy up highly undervalued companies.
Examples of Stock Market Corrections
There have been nearly 40 corrections in the US stock market between 1980 and today. One of the most recent was in the fall of 2018, when the S&P 500 fell 17.5% over a span of three months. The correction ultimately marked the continuation of the long-term bull market, though, and the market gained more than 40% over the following 14 months.
The market downturn in March 2020, which was a reaction to the COVID-19 pandemic, could also be considered a correction – one which was severe enough to be classified as a bear market. In that event, the S&P 500 lost 34% in just over one month of trading. In the year after the correction, though, the market gained 43%.
What to Do During a Stock Market Correction
How you should respond to a stock market correction depends on your investing goals and time horizon.
If you’re a long-term investor, the best thing you can do during a correction is to simply hold the course. Don’t sell off stocks just because they’re losing value. In the big scheme of things, the loss is likely to be temporary and you’re more likely to miss out on the post-correction recovery if you try to time the market.
That said, you can use the correction as a chance to re-evaluate your positions. If you have stocks that underperformed before the correction, you could sell them and invest the money in a company that you think is a better fit for your portfolio. In addition, if you have cash sitting around that you’ve been waiting to invest, a correction is the perfect time to double down on the stocks you already own at a bargain price.
If you’re interested in short-term trading, a correction provides plenty of opportunities since volatility is often high. Just be careful trying to time the market to line up perfectly with the correction. These events are notoriously difficult to predict, and you’re more likely to lock in gains if you’re not trying to hit the exact top or bottom of the market.
Conclusion
Stock market corrections might not feel very comfortable, but they’re essential to the proper functioning of the market. These downturns happen roughly once a year and they typically last just a few months or less. Long-term investors largely shouldn’t be concerned about corrections, except to use them as an opportunity to buy stocks at a discount.
