What Is a Market Correction and What’s It Mean for You?
When the stock market drops enough to make people jittery, there will no doubt be a debate about whether it’s the start of a crash or “just a correction.” Anyone who lived through 2008 knows the damage that a crash can do, but crashes are much more destructive than corrections and, thankfully, much less common.
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Every stock market crash in history, however, was just a correction that never ended, and what appears to be a correction can actually be the beginning of a bear market. But corrections can bring opportunity, too.
Here’s what you need to know.
Corrections Are Significant, but Modest and Short-Lived
A correction is a drop of 10%-20% in the price of a market index like the S&P 500 or even an individual stock like Amazon. While a double-digit dip is significant, corrections are a normal, natural and common part of investing — and no two are the same.
For example, in February/March 2020, at the start of the pandemic, a market correction lasted three months, according to Forbes. A few months later in September, another correction lasted only three weeks.
In total, the S&P 500 has experienced 27 corrections since World War II, and Motley Fool data show that all but a handful were short corrections that lasted less than 100 days. According to Forbes, the market takes an average of four months to recover to its previous highs in the wake of a correction.
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Crashes Are Corrections Without Bottoms
When a market correction’s decline reaches 20%, it becomes a crash and the start of a bear market. Unlike relatively short-lived corrections, bear markets last an average of 14-16 months, according to Forbes, which means that investors suffer much steeper losses for much longer periods of time. Bear markets are often accompanied by wider economic suffering, like higher unemployment and stalled growth.
Much of the reason that most corrections don’t become crashes has to do with investor sentiment.
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Corrections often follow a significant economic, social or political shock that jolts the public into selling shares and harvesting gains in case things get bad. The underlying sentiment regarding the fundamentals of the market and the economy, however, is still optimistic. When the selloff causes prices to fall, bargain-hunters jump in and buy those shares at a discount, which sends the price back up once the correction reaches its floor.
When larger, foundational problems make investors leery, on the other hand, the early selling leads only to more selling. In 2007, for example, what started as a correction evolved into a bear market when it became clear that the housing market was in an unsustainable bubble.
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Corrections Keep Markets Healthy and Offer Opportunity
No one likes to open their laptop and see a bunch of red ink splashed across their ETF chart, but like spiders and mosquitos, you wouldn’t want to live in a world without market corrections no matter how unpleasant it may be when one bites you.
Corrections bring artificially inflated stock prices back down to Earth before they become dangerous bubbles that can trigger crashes — and they can also be a great time to buy.
Publications like Forbes and Business Insider point out that corrections are significant enough to offer deep discounts — if you buy at or near the bottom of one, you can make gains on the entire ride back up to even and beyond.
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The trouble with that, however, is that you won’t know whether a sudden drop is a correction or a crash until it’s over. Bargain hunters who bought into what they thought was the temporary dip of a correction in 2007 threw good money behind bad money and bought into a stock market that was just getting started on an endless race to the bottom. If you panic and sell prematurely, on the other hand, you lock in losses and miss out on the recovery.
Most experts, therefore, continue to recommend building a portfolio that matches your risk tolerance, sticking with it for the long term, and not adjusting your strategy in the face of a correction.
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This article originally appeared on GOBankingRates.com: What Is a Market Correction and What’s It Mean for You?
