Stock market corrections are scary but normal. They're a sign of a healthy market in most cases. A stock market correction is usually defined as a drop in stock prices of 10% or more from their most recent peak. If prices drop by 20% or more, investors refer to it as a "bear market."
- Stock market corrections are a regularly occurring market condition.
- You should resist the urge to trade on market corrections.
- Corrections are best weathered by having a diverse portfolio designed to reduce risk.
Frequency of Market Corrections
The S&P 500 Index has recorded 54 market corrections and bear markets since 1928. The longest market correction on record lasted 929 days from March 2000 to October 2002; the highest loss was -59% from October 2007 to March 2009.
In 2020, the coronavirus pandemic rocked the stock market, sending it into another bear market. But within five months, the S&P 500 had made a full recovery and set new record highs.
How to Withstand a Correction
Anticipating a correction can be stressful. First, resist the urge to "time the market." Although it's possible to make some short-term money trading the ups and downs of the market, strategies like swing trading rarely work for building long-term wealth.
Most people lose by moving their money around to participate in the ups and avoid the downs. This is a documented behavior studied by academics around the world. The field of study is called "behavioral finance."
Data show that not only do most people lack the discipline to stick to a winning investing playbook in correcting markets, but they also tend to transact at the wrong times, causing even larger losses.
Professional financial planners build portfolios based on science versus behavioral biases. When we create a portfolio, we should expect that one out of every four calendar quarters will have a negative return. We can help to control the magnitude of the negative returns by selecting a mix of investments that have either more potential for upside or less potential for high returns and also less risk—a process called "diversification."
If you are going to invest in the market, it is best to understand that corrections occur, and it’s often best to just ride them out.
Resist the urge to trade and profit from corrections. Follow the old Wall Street adage "Never catch a falling knife.
The Dow Jones Leading Up to 2018
In the five years before 2018, the Dow Jones Industrial Average nearly doubled without any meaningful pullback. For each of those years, a significant number of analysts anticipated a correction or even a recession.
These predictions have caused investors to pull out of the market too early and lose the impressive gains they could have enjoyed if they hadn't tried to predict when the inevitable would come. This is true of individual investors as well as professionals.
Control the Magnitude of Corrections
You can control the magnitude of the market corrections you might experience by carefully selecting the mix of investments you own.
Understand the level of investment risk associated with an investment. For example, in an investment with high risk, there is the potential to lose all of your money. With slightly less risk, you might experience a drop of 30% to 50%, but you won’t lose it all. That’s a big difference in risk.
Next, understand how to mix these different types of investments to reduce the risk to your portfolio as a whole.
Keeping your investment portfolio balanced is part of what's known as the "asset allocation" process.
It's important to reduce your exposure to significant market corrections as you near retirement. Once retired, you should structure your investments so that you are not forced to sell market-related investments when market corrections occur. Instead, you use the safer portion of your portfolio to support spending needs during those times.
Learn about the risk-return relationship of investing. The potential for higher returns always comes with additional risk. The higher and faster the price of the stock market rises, the less the potential for future high returns.
Just after a stock market correction, or bear market, the potential for future high returns in the market is higher. In 2017, cryptocurrency became the craze. It had a return of more than 1,000% that year, and retail investors scrambled to get in, while professional traders stayed away.
It's important to understand that when prices go up that much, they will eventually experience a severe correction.
Lastly, if you don’t want to face the potential to experience a market correction, it is probably best to avoid investing in the stock market altogether. Instead, stick with safer investments. But safe investments have what we call "opportunity cost"—you miss the opportunity to set yourself up for the future life you envision for yourself and your family. The key is to strike a good balance.
Frequently Asked Questions (FAQs)
What is swing trading?
Swing trading is when you buy and hold a stock for at least one day and as long as several weeks. The goal is to capture short- to medium-term gains. This is in contrast to day trading, in which positions are held for less than one market day. Both of these approaches are time-consuming and carry risk. If you're investing for the long term, you'll typically want to buy and hold a diverse portfolio of stocks and other assets.
What is diversification?
Diversification is a risk management strategy. It involves having a variety of investments in your portfolio. Diversification might involve different asset types, like mutual funds, stocks, bonds, and ETFs. It might also involve diversifying within each asset type. For example, you might buy mutual funds that focus on different sectors or from companies of various sizes. You might also diversify by having foreign investments as well as domestic ones.
The Balance does not provide tax, investment, or financial advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.