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Market Correction

A dip of 10%-20% in a stock market index

What is a Market Correction?

A market correction refers to a dip of 10%-20% in a stock market index. It can precede a bear market, which is a drop of 20% or greater in a stock market index. More broadly, a correction is a 10% to 20% drop in a stock market index or individual securities.

 

Market Correction

 

Summary

  • A market correction is a dip between 10%–20% in a stock market index.
  • Market corrections can be viewed as a healthy pullback between the market index continues its uptrend.
  • Given the inability to accurately predict a market correction, it is important to ensure that your investment portfolio is best positioned to withstand a surprise correction.

 

Understanding Market Correction

A market correction is described as a drop of at least 10% but less than 20% in a stock market index from recent highs. It can be triggered by a number of factors, such as an overbought (overheated) market, negative headlines news, economic shocks, or major negative events.

When a stock market index rises steadily for an extended period, a market correction can be viewed as a healthy pullback before the market index continues its uptrend. It is because market corrections can help readjust the valuation of asset prices that have become unsustainably high. Market corrections tend to be short-lived, with the average market correction lasting about four months.

 

Is a Market Correction the Start of a Bear Market?

Although a market correction can precede a bear market, it does not happen often. Since World War II, the S&P 500 has experienced 27 market corrections. Over the same time period, the S&P 500 has only seen 12 bear markets.

In the event that a market correction precedes a bear market, it is usually caused by a lasting negative economic shock, such as market bubbles bursting, geopolitical crises, economic slowdown, and/or overly contractionary monetary or fiscal policies.

 

Market Correction vs. Bear Market

In contrast to a market correction, a bear market results in a greater drawdown – more than 20% – and lasts longer (a bear market can last years). Bear markets are represented by a more significant negative change in sentiment among investors, while a market correction represents near-term concern about the market but an overall positive outlook.

In a market correction, the broader outlook on the market by investors is negative, causing reluctance to step in and invest. This is a key reason why a bear market lasts longer versus a market correction.

 

How to Prepare for a Market Correction

Predicting a market correction is difficult, if not impossible. In February 2021, Tobias Levkovich, Citi’s Chief U.S. Equity Strategist, called a 10% pullback in U.S. shares “very plausible,” which failed to materialize in 2021.

Given the inability to accurately predict market corrections, it is crucial to ensure that your investment portfolio is best positioned to withstand a surprise market correction. It is important to:

 

1. Define your investment time horizon

Investors with a shorter investment horizon should consider less risky assets. A glide path is commonly used to identify the suitable asset mix at a given time. As an investor is nearing their retirement date, a portfolio should be tilted more towards lower-risk assets.

 

2. Lock in profits

If you believe the market is due for a market correction, it may be advisable to sell your most profitable investments to keep dry powder to invest during a potential market correction.

 

3. Reevaluate your risk profile

The level of risk an investor is willing to accept differs depending on their existing financial condition and investment horizon. It is important to frequently evaluate your portfolio’s risk profile to ensure that a market correction does not have a material impact on your ability to meet your living expenses.

 

4. Rebalance your portfolio regularly

Changes to the market can affect your portfolio’s strategic asset allocation. Assets that have gained in value will comprise more of your portfolio, and assets that have declined in value will account for less.

Rebalancing involves selling positions that have become overweight in your portfolio in relation to your strategic asset allocation and buying positions that have become underweight in your portfolio. This helps to better manage risk.

 

Learn More

Thank you for reading CFI’s guide to Market Correction. To learn more about trading, investing, and related topics, we highly recommend these additional free resources:

  • Contractionary Monetary Policy
  • Overweight Stock
  • Stock Market Index
  • Tactical Asset Allocation (TAA)
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