What is a Market Correction?
When a stock index falls more than 10% from a recent high, it is considered to have entered “correction” territory. Corrections are a fairly neutral term for what can eventually turn into a market crash or even recession.
While downturns of 10% can be an unpleasant experience for many investors, it is an event that occurs quite commonly in the stock market and is not an indication of any future results.
What is a Market Correction?
A market correction is typically defined as a decline of between 10% and 20% in the price of a security, index, or asset class from its most recent peak.
Corrections can happen to the Dow Jones Industrial Average index, another market index, a commodity index, another asset class, or even shares of an individual stock.
How Long Do Market Corrections Last?
This is something every investor wishes they knew. Still, while there is no surefire timeline to follow, there are some guideposts for how long crashes, corrections, and bear markets last.
Historically, corrections have typically lasted around four months on average. Bear markets tend to be longer: in the three confirmed bear markets since 1990, the average decline has been 46.5% over 1.4 years.
In contrast, the last three bull markets have lasted nearly nine years on average. Declines tend to be short-lived, especially relative to uptrends.
Market Correction vs. Market Crash
While both corrections and crashes refer to market downturns, there are some key distinctions between the two. A crash refers to a sharp drop in stock prices, typically above 20%, over the course of just a few days. A correction tends to happen at a slower pace and less drastically, declining between 10% and 20%.
Like other measures of economic health, stock market corrections and crashes can only be known once they are over. A correction is defined as a drop of between 10% and 20%. If a stock drops more than 10%, entering correction territory, investors won’t know if it’s “just” a correction or a more serious crash until it recovers or drops more than 20%.
Corrections are more subtle than crashes and sometimes are even thought to be healthy for markets that are rising too rapidly. Like the name suggests, they correct prices back down from an elevated level.
Correction vs. Bear Market
The difference between a correction and a bear market is in the magnitude of the market decline. A bear market begins at a decline of at least 20% from a recent peak while a correction is a decline in the range of 10-20%.
Bear markets also tend to last longer than corrections because they typically reflect an economic reality such as a recession, rather than the type of short-term concern that is represented by corrections.
The challenge for investors is that it’s very difficult to determine in real-time if a market is simply correcting or if it will become a bear market.
What Causes a Market Correction?
Market corrections occur because investors are more motivated to sell than to buy. Investors are forward-looking, trying to determine whether their investments will appreciate or depreciate in value. They watch for signs, including news, rumors, and data to indicate how the market will move.
While hardly any investors want the market to sell off, corrections are a regular feature of markets as a whole. Several factors can contribute to or even create market conditions for correction.
Over the long haul, the stock market’s direction follows corporate earnings, which affects companies’ stock prices. When earnings are forecast to rise, the stock market tends to follow suit. The same is true of the opposite: when earnings fall, stock prices tend to follow.
For an individual company, missing earnings expectations can send that specific stock into a correction because investors think the fundamentals point to the share being overvalued. These tend to not have impacts on other companies.
However, if the overall global economic outlook dims, many companies will be affected. When entire sectors or segments of the market begin to pullback, the market as a whole tends to go through a correction.
Technical analysis in the stock market is devoted to tracking the trading patterns of individual stocks and the market. Based on the past performance of stocks after they trade in particular patterns, technical analysts try to predict future price movements.
Suppose stock charts indicate that a group of stocks, or the market as a whole, is in a pattern that has historically resulted in a correction. In that case, investors who utilize technical analysis will likely sell stocks.
If enough investors make this investment decision, a correction occurs in order to bring valuations down to a level investors feel comfortable with.
Decline in Investor Confidence
While the stock market can seem like a complex science, it’s actually driven to a large degree by the emotions of investors and consumers, particularly fear and greed. When investors get scared they tend to sell off.
Often selling can snowball as investors panic when they think they won’t be able to get out of their stocks at a decent price. Sometimes it’s simply a rumor that triggers fear in the market, other times the market truly is overheated and needs to slow down in order to correct.
Another reason more investors would be looking to sell rather than buy is an external event impacting the stock market. For instance, issues like supply chain backups or interest rate hikes can trigger sell-offs as investors want to move their money toward more stable assets.
Similarly, big-picture issues like the COVID-19 pandemic or international military tensions can trigger market fear and lead to corrections or even a stock market crash. Each case is different and the cause or causes of a market correction can usually be identified in hindsight.
How Often Do Market Corrections Occur?
Market corrections are common enough but don’t occur at regular intervals and can be difficult to predict.
There have been 14 measured market corrections between 1990 and 2021, only three of which became severe enough to be considered bear markets or recessions (which began in 2000, 2007, and 2020).
The average interval between corrections was 673 days but these intervals ranged wildly. The nearest corrections were a mere 49 days apart while the farthest were about 7 years apart.
What are Common Effects of a Market Correction?
The S&P 500 is the usual benchmark investors use to approximate the overall market. But unless an investor exclusively owns shares of an S&P 500 index fund, their actual returns will differ from the market’s because they don’t own the same stocks in the same proportions.
Gauging how you’ll fare in a market correction depends on the composition of your portfolio. The performance of individual stocks tends to experience more volatility than the market. If the S&P 500 were to drop 10%, individual stocks in a portfolio could fall 3%, 5%, 15%, or 40%. Some stocks might even appreciate.
Investing During a Correction
For most investors, market corrections are so short-lived that their portfolios will not change at all. Corrections are expected as a part of a long investing life. A short-term decline of around 10% likely won’t make a dent in returns made over decades.
Trying to shift out of the market if you anticipate a correction is generally a poor investment strategy because predicting corrections is near impossible without a crystal ball. However, there are some common ways that some investors will take advantage of corrections.
For investors who participate in workplace retirement plans such as 401(k) or IRA, or invest in a stock index, the purchases made during a market correction will earn higher returns than those made at higher prices. This is called dollar-cost averaging and works because you’ll purchase more shares per dollar when the market is in correction. This allows investors to take advantage of short-term declines.
Buy the Dip
If you find yourself with extra cash to invest, corrections are known to be a good time to invest because prices are more attractive. It’s important to note that there is no way to tell if the market is merely correcting, or if the decline is indicative of a longer-term decline.
Review Risk Tolerance
It’s pretty easy to take risks when the market is climbing, but market downturns can be a time to assess how much risk you are comfortable taking.
Stock market corrections, or corrections in other areas of the market, happen occasionally, but long-term investors shouldn’t be massively concerned about them.
Rather than trying to make risky predictions based on news, tips, or technical analysis, most casual investors hold their portfolios through short-term volatility and even some extended dips, as the market tends to move upward in the long term.
Passive investing strategies like dollar-cost averaging and diversification can help investors reduce the impacts of market volatility on their portfolios and financial plans.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision