Correction is a fancy term that financial analysts use to describe a market slide, but it can also be an unpleasant experience for investors and traders.
The word most times evokes pessimism and the notion that a bear market would be approaching.
However, experienced investors know that corrections are healthy for markets and present opportunities to rebalance the portfolio to optimize gains. This article explains what a correction is, and what investors can do when the market enters correction territory.
A stock market is deemed to have entered the "correction" zone when it drops more than 10% from its recent peak.
For example, if the S&P 500 index, Nasdaq Composite, or Dow Jones Industrial Average declines by more than 10% (but less than 20%) from its most recent highs. It’s called a correction because the drop often “corrects” and returns the prices of assets to their fair value.
An asset, index, or market may enter correction for a short time or a long period—days, weeks, months, or even years. However, the average market correction period lasts between three and four months.
It is very difficult to say with certainty if a correction will revert or morph into a bear market.
However, based on previous occurrences, there is a high probability that a correction won't turn into a bear market. Historical data shows that only 5 corrections have morphed into bear markets in about the last 50 years.
Since November 1974, there have been 24 market corrections, with only five of them becoming bear markets (1980, 1987, 2000, 2007, and 2020).
Excessive worry about if a correction would lead to a bear market might backfire, by making you make wrong investing decisions.
Being prepared for a correction is always a smart idea. The following are some steps investors and traders should think about in the event of a major downturn.
Before making any moves, it is expedient that you take a step back and understand the underlying macroeconomic developments that are causing the correction.
There are a plethora of macro-economic developments which could move markets such as:
If there have been changes impacting broader stock markets, it might be a cue to prepare for an extended correction or even a bear market. This does not imply selling assets. On the contrary, you may need to readjust to less volatile areas in the market, and more value stocks.
A documented financial plan can assist you in creating a well-balanced portfolio.
It can also help to calm your nerves and stay the course when markets are volatile. If you don't have a financial plan, you must consider developing one before you even think of trading or investing.
When the market is rising, it's relatively easy to take risks, but market downturns can serve as a reminder to reconsider your target asset allocation.
Consider how much loss you can cope with emotionally and financially.
Rebalancing at regular periods is a good idea because market volatility may cause your allocation to deviate from its initial goal.
Rebalancing entails selling investments that have become overweight in comparison to the rest of your portfolio and reinvesting the proceeds in underweight positions.
When rebalancing, it is important to put your life stage into consideration. If you’re a younger investor saving for a goal that is 15 or more years away, you have time to potentially recover from a market drop. However, the picture may change for investors nearing or in retirement
Make sure you have enough cash on hand to take advantage of short- or long-term drops without hurting your portfolio.
Having cash at hand is keeping gunpowder to pounce when opportunities present themselves. It also helps to buy stocks cheap and reduce the effect of the market downturn on your portfolio by averaging costs.
Stock market corrections are a typical part of the market cycle, and the best thing you can do during one is to stay the course.
Stick to your financial strategy and don't let fear influence your choices.
Remember that market corrections are usually short-lived, so selling in the middle of one will not benefit your portfolio and may even lock in your losses.
Instead, think of a stock market drop as an opportunity to buy more assets at a reduced price, then reap the benefits when the market recovers.
Photo by Scott Graham on Unsplash
LATEST
