What is a market correction?
The stock market has largely been in a tear since it hit a low in March 2020 at the height of pandemic concern. The S&P 500 Index has nearly doubled since then, rising 96.4% to an all-time high on July 14. But some market commentators are concerned that prices may have risen too quickly, leading them to suggest that a correction may be just around the corner.
But what exactly is a market correction and what can you do about it? Here’s what you need to know:
What is a correction and what are the causes?
A correction is a drop of 10% or more from an asset’s most recent high. For a stock that recently hit an all-time high of $ 100 per share, a correction would occur if the stock fell to $ 90 or less. Corrections can occur in any financial asset such as individual stocks, general stock indices like the S&P 500 or commodities. The S&P 500 would need to fall to 3,954 or lower for a correction to occur based on the July peak.
Corrections can be caused by a number of different factors and are difficult, if not impossible, to predict in advance. Short-term worries about economic growth, political issues, or a new variant of the COVID-19 virus all have the potential to trigger market corrections. These problems cause investors to fear that their previous assumptions about the future are not correct. When people are scared, they usually look to sell stocks for the benefit of assets considered safer, such as US Treasury bonds.
Difference between a fix and a crash
A market correction can look like a crash, but there are some key distinctions between the two. A crash is a sharp drop in stock prices, typically a double-digit percentage drop, in just a few days. A correction tends to occur at a slower rate, making the drop less steep than a crash would. One of the most famous stock market crashes occurred in October 1987, when the Dow Jones Industrial Average fell 22.6% in a single day, historically known as Black Monday.
Corrections are more subtle and are even sometimes seen as healthy for rising markets as they keep things from overheating. As the name suggests, they correct the prices from a slightly high level.
Difference between a correction and a bear market
The difference between a correction and a bear market is in the magnitude of the decline. A correction is a decline of at least 10%, but less than 20%, while a bear market begins at a decline of at least 20% from a recent peak. Bear markets also tend to outlast corrections, as they tend to reflect an economic reality, such as a recession, rather than a short-term concern that may or may not materialize. The challenge for investors is that it is very difficult to determine in real time whether a market is right in a correction or if it could turn into a bear market.
What should investors do during a correction?
For most people, the answer will probably be nothing. Corrections are to be expected over a long investment life, and a short-term decline of around 10% is not much when compared to the return you are likely to earn over decades. Trying to exit the market when you anticipate a correction is not a wise strategy, as you are likely to predict more corrections than what actually happens. However, there are some ways to take advantage of the corrections.
If you participate in a workplace retirement plan such as a 401 (k) or contribute regularly to an IRA, the purchases you make during market corrections will generate higher returns than those made at higher prices. . This approach is known as cost averaging and will help you take advantage of short-term declines.
If you happen to have extra cash to invest, corrections may be a good time to implement them because the prices are more attractive. But be careful not to wait too long to invest or you could end up paying higher prices than if you had consistently bought along the way.
At the end of the line
Market corrections do happen occasionally, but long-term investors shouldn’t be overly concerned about them. Focus on achieving your financial goals and try to take advantage of falling prices by investing in your retirement accounts regularly. Stocks are volatile, but that’s why they’re part of your long-term goals, not your short-term needs.