A stock market correction is when the market falls 10% from its 52-week high. This may sound like a bad thing, but wise investors welcome it because the pullback in prices allows the market to consolidate before going toward higher highs. Each of the bull markets in the last 40 years has had a correction. It's a natural part of the market cycle, and corrections can occur in any asset class.
Market Correction Example
On Jan. 26, 2018, the Dow Jones Industrial Average entered a correction, hitting its highest closing record of 26,616.71. The next day, it went into free fall. By the end of the following week, it had fallen 4%. It recovered briefly before dropping 1,032.89 points on Feb. 8 to 23,860.46. In total, it had fallen 10.4%, and investors were wary of higher interest rates and afraid of inflation.
A correction is caused by an event that creates panicked selling, and many beginning investors will feel like joining the mad dash to the exits. However, that's exactly the wrong thing to do because the stock market typically makes up the losses in three months or so. If you sell during the correction, you will probably not buy in time to make up for your losses.
Corrections are inevitable. When the stock market is going up, investors want to get in on the potential profits. This can lead to irrational exuberance, which makes stock prices go well above their underlying value. A correction happens when those prices return to a sensible level.
Correction Versus Crash
In a correction, the 10% decline will manifest over days, weeks, or months. In a stock market crash, the 10% price drop occurs in just one day. These crashes can lead to a bear market, which is when the market falls another 10% for a total decline of 20% or more.
How does a stock market crash can cause a recession? Stocks are shares of ownership in a company, and the stock market reflects investors' confidence in the future earnings of those corporations, making the stock market an indicator of economic health. A crash signals a massive loss of confidence in the economy. Plummeting stock values reduce investors' wealth, and a stock market crash may frighten consumers into buying less. Consumer products are the largest component of gross domestic product, as they comprise almost 70% of the economy.
Firms that don't produce will eventually lay off workers to stay solvent. As workers are laid off, they spend less, and a drop in demand means less revenue, leading to more layoffs.
How to Protect Yourself Right Now
The best way to protect yourself from a correction will also protect you from a crash, and that's to develop a diversified portfolio as soon as possible. This means holding a balanced mix of stocks, bonds, and commodities. These stocks will make sure you profit from market upswings, and the bonds and commodities protect you from market corrections and crashes.
The specific mix of stocks, bonds, and commodities is called your asset allocation; this depends on your personal financial goals. If you don't need the money for years, then you'll want to have a higher mix of stocks. If you require the money next year, you'll want more bonds.
The best way to create the right asset allocation for your goals is to work with a financial planner, as they have computer programs and certain insights that determine the right mix for you. Your planner can also suggest good individual stocks, bonds, or mutual funds that have a proven track record.
Once you are well-diversified, make sure you rebalance your portfolio every year. If commodities do well and stocks do poorly, your portfolio will have too high a percentage of commodities. To rebalance, you should sell some commodities and buy some stocks. That forces you to sell the commodities when prices are high and buy the stocks when prices are low. With diversification, you will feel safe to ride out any stock market corrections.
If you want, you can take further precautions. When stock indices like the Dow hit record highs, sell some of your winners, and hold this money in a liquid account like money markets or Treasuries. You could also buy gold if the stock market corrects. Studies show that gold prices increase for 15 days after a crash.
If a correction hits, use that cash to buy some stocks at lower prices. You could use dollar-cost averaging to slowly buy back in after the market falls 5%, then again at 10%.
You must protect yourself before prices begin to fall, as a crash often happens too fast to respond. Trying to decide if a correction is turning into a crash is known as timing the market—this is almost impossible to do. Just when you're sure the 5% drop will turn into a 10% correction, the market may rebound and hit new highs.
On average, the stock market has several corrections a year. Between 1983 and 2011, more than half of all quarters had a correction; that averages out to 2.27 per year. Fewer than 20% of all quarters experienced a bear market, averaging out to 0.72 times per year.
Stock corrections are more frequent than crashes because they occur when the economy is still in the expansion phase. But you may be wondering why the market would correct even when economic data is upbeat. This is because the stock market is a leading economic indicator, and investors look at future expected earnings to forecast corporate profits. They buy or sell stocks based on these projections, and sometimes investors become too optimistic, creating a rally that exceeds current economic performance. That's when the market gets over-extended. Once that happens, any bit of doubtful news causes a correction.
As long as the future trend remains optimistic, the buying will resume. That leads to an even stronger bull market rally. In other words, a stock market correction can help the stock market catch its breath and hit even higher peaks.
Most recessions occur with stock market declines of 20% or more. That's the contraction and trough phase of the business cycle. A crash can create them, but larger economic events are the underlying cause, which is what makes a crash more devastating than a correction.