It doesn’t matter if you’re a new or seasoned investor, when the stock market has a correction, it can be extremely stressful. Nobody likes to see their portfolio decline significantly in a single day.
Stock market corrections are normal and it’s important to be aware of why they happen and what you can do when the next one occurs.
It’s worth mentioning that the following is not financial advice, but instead is a way to broaden your knowledge about stock market corrections. Always consult with a professional before making decisions regarding your own stock investments.
Related: Understanding stock volatility
What Is a Stock Market Correction?
A stock market correction happens when the market reaches a new interim high and then falls by 10%. Some other stock market terms for market downturns include:
- Dip: A dip is a temporary market downturn from a longer-term uptrend. This downturn could occur over a number of days or weeks.
- Crash: A crash is a very fast and significant drop in the stock market which could occur on a single day or week. Crashes are very rare and typically happen after the market has been rising for a long period of time.
- Bear Market: A bear market is a longer decline in the stock market. Once the market has gone down by 20% from its previous high this is considered to be a bear market.
These terms can also apply to individual stocks, but individual stocks can see much more volatility than the overall market.
The most severe stock market correction in history, in terms of points, happened in 2018, when the Dow declined 1,175 points in a single day.
Previously, the record had been a 777-point decline.
However, the 2018 4.6% drop wasn’t the biggest decline in terms of percentage. In 1987, on a day called Black Monday, the Dow dropped by 22%. That would be equivalent to 5,300 points in today’s market.
Stock Market Correction History
Since 1950, stock market corrections of 5% to 10% have typically happened three to four times every year. Although it’s nerve-wracking every time, these corrections are a normal part of the market cycle.
What Causes a Stock Market Correction?
Many different factors can cause a stock market correction. Essentially, something has to happen to motivate people to sell stocks rather than buy term. Here are a few things to look out for which may cause a market correction:
Fear
One factor is when investors have an emotional reaction to a news story that causes them to sell their stock holdings. It could be a story about the economy, a political situation or other news.
Sometimes news is an actual indicator that the economy is heading into a recession or that the markets won’t perform well in the coming weeks or months, but sometimes people overreact to news or act based on fear. Once the news gets out that the stock market is falling, this fear typically only increases.
A Slowing Economy
A legitimate reason for investors to decide to sell their stocks is if the economy is slowing down or entering a recession. Although timing the markets isn’t usually a good investment strategy, many investors may not want to hold onto their stocks through an economic downturn cycle.
Outside Events
World events unrelated to the economy can also cause investors to sell their stocks. This could include things like a war, a terrorist attack or an oil spill.
What Is a Circuit Breaker?
Following significant stock market declines in 1987 and 1989, the New York Stock Exchange imposed limits on trading in order to try and prevent panic selling.
The “circuit breaker” can be triggered in a few ways. All trading on the New York Stock Exchange pauses for 15 minutes if the S&P 500 goes down by 7% in a single day. When trading starts again, if the market continues to fall and reaches 13%, trading once again pauses for 15 minutes.
These circuit breakers both apply until 3:25 p.m. Eastern Time. After that time, if the market falls by 20% then all trading stops for the rest of the day.
How Long Do Stock Market Corrections Last?
Do you have a crystal ball?
When a correction occurs, you will likely see the media speculate whether it’s a crash or a correction, how long the correction will last, and perhaps, if the economy is going into a recession.
This speculation is just that. There is no way of knowing exactly how big a correction will be or how long it will last.
Focusing on your own portfolio rather than the news stories could help you feel more prepared for the next correction (which could mean having a chance to take advantage of cheaper stock prices).
A stock market correction is not typically the cause of a recession, nor is it a predictor of a coming recession. Stock market corrections can be stressful for investors and companies, but they are not necessarily signs of a poor economy.
Although there is no way of predicting how long a market correction will last, you can look to past data as some indicator of possible trends.
For example, since the 2008–2009 financial crisis, the past four corrections have had an average decline of 15.3% over a time period of three and a half months.
What to Do During a Stock Market Correction
First of all, remain calm.
Unless you exclusively own stocks in an S&P 500 index fund, your portfolio will perform differently from the overall market. When a stock market correction occurs, the percentage drop is generally referring to the performance of the S&P 500 index. This is an index of the largest U.S. companies in the stock market.
The stocks in your portfolio may fall in value more or less than the overall market. Some of your stocks may even go up in value. It’s important to remember that if your portfolio drops by a certain percentage, it will need to go up more than that percentage to recoup your losses.
The first step in knowing what to do during a stock market correction is to find out why it’s happening. Next, look into your individual portfolio and see how it’s being affected by the correction. This will help you decide whether to buy, sell or hold on to the stocks in your portfolio.
Remember that stock market corrections are normal. If you have a long-term investing strategy, you will likely see market corrections, bear markets, and recessions during your years of investing. Try to stay calm and reconsider decisions that might be made based on fear or panic. It may not help to obsess over the value of your portfolio on any particular day.
Generally, if you don’t need access to the funds in the near term, the rule of thumb is to stay invested. If, for example, someone sells off their stocks during a panic, they could see them go back up in value again in a few days or weeks. If anything, depending on your strategy and goals, you may want to consider buying stocks during a market correction, because prices will have lowered.
The people who held on to their investments through the recent financial crisis not only recovered their losses, they saw significant growth to their portfolios within just a few years. The average annual return of the S&P 500 has been 8.6% each year from 2008 to 2017.
So you could consider whether you have available funds you’d like to invest during a downturn, and decide if you want to purchase more shares of stocks you already own or if you want to find new stocks to buy. Diversifying the stocks in your portfolio may help you weather the storm of a market correction.
If you do choose to purchase stocks during a market correction, be aware that their value may continue to decline before it recovers again.
Also remember that the market has bounced back from some severe corrections and crashes over the years. Corrections happen every year and can be healthy for the market. If the market doesn’t correct, stocks can become overvalued, but if it goes through minor corrections it can continue to grow sustainably.
Preparing for a Market Correction
With the proper planning and goal setting, it’s possible to build a portfolio which will grow over time and not be completely wiped out by market crashes. Here are a few principles to keep in mind when building a portfolio:
Having a Plan
Blindly buying stocks and then getting upset when they fall in value isn’t ideal. Know what your goals are and plan for them. Even when the market corrects, you can still reach your goals for the year if you plan properly. If you’re investing money to use in just a few months versus for your retirement, your strategy may look very different.
Diversifying
One way to protect yourself from significant market crashes is to spread out investments over different types of assets. This is called diversifying your portfolio, and this tactic may help lower your risk of losses while still exposing yourself to potential gains. You can diversify into many different types of investments, including bonds, real estate, commodities, and simply by holding cash.
One potential way to maintain a diversified portfolio is to rebalance your holdings when the market is at a high. Since certain stocks may have grown significantly more than others, you might choose to take some of that money and put it into other assets.
By moving some money from a stock into bonds or other potentially safer assets, you might be able to mitigate some of the risk of a crash.
Another way you can help protect your portfolio is via options. Options give you the right to buy or sell a security at a fixed price on a future date. This can give you some insurance on a valuable asset should the market rise or fall in the near future.
Considering Taking Profits
Investors can be afraid to cash out of a particular stock because it may continue to rise in value. If you own a stock which has gone up significantly, you may want to cash out some of the investment and diversify it into other investments.
Or you can keep some of your money in cash and wait until you see an opportunity to buy during a dip.
Knowing Your Risk Tolerance
If you are growing your portfolio for long-term use, you can likely handle a few ups and downs in the market cycle. However, if it causes you too much stress to see your portfolio go down in value a lot in one day, perhaps it’s better not having so much invested in stocks.
You could instead look into investing in other assets, such as bonds, which are less volatile. You could also keep some of your portfolio in cash.
Knowing what your investment goals are and planning your portfolio accordingly are key. If you plan to take your money out in just a few months or years, you may not want to risk losing it to a market correction.
Don’t Get Greedy
It can be hard to stand on the sidelines when the market is significantly increasing in value, but make sure to think through all of your choices before you invest.
Currently, the U.S. market is in a long bull run, as it’s been nearly a decade since the last recession. Although it isn’t wise to try and time the market, it’s common knowledge that stocks are hitting record highs and also that we may head into a recession some time in the next few years.
You may still choose to invest money into the market now, but you may not want to do so unless you talk through your plans with a financial advisor. This is always a great idea—licensed financial advisors have the experience and credentialed to offer guidance for your unique needs and wants.
Don’t Attempt to Time the Market
On the same note, selling off your investments because you think the market is going south may not be a great strategy. The stocks you’re holding may continue to go up in value, and even if they do crash, trying to time your reentry can be just as challenging as timing your exit.
Knowing exactly when to buy stocks is extremely complicated and very risky. Building your portfolio over time, rebalancing it, and holding on to it for the long run are hallmarks of a solid investment strategy.
Thinking Long Term
Day trading and short-term investing are risky. If you build a diversified portfolio which you plan to keep invested for a long time before using it, it may be able to withstand cycles in the market and still continue to grow.
Don’t Go It Alone
As you build your portfolio and mentally prepare for the next stock market correction, remember that you are not alone. Market crashes are stressful for everyone, and there are tools and specialists to help you navigate them.
Working with an investment advisor may help you stay calm throughout economic cycles. Planning your portfolio for diversification and long-term growth may also help you ride the waves of the market.
You can build a portfolio using comprehensive tools right from your phone.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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