By Coryanne Hicks, Staff Writer
A stock market correction occurs when a market index reverses direction by at least 10 percent. Typically corrections are negative, meaning the market had been on a nice upward trend and then takes a turn for the worse, declining by at least 10 percent from its previous high. While this might sound like the end of our happy bull market, corrections are not the pivotal moment they may appear.
What causes a stock market correction? Corrections are caused by a sudden sell-off in the market. Any number of events could trigger a market correction, from investors thinking the market is about to peak to sudden spikes in long-term bond yields like the one we experienced last week. Whatever the cause, corrections are short-lived, typically lasting no more than eight weeks. More importantly, a correction does not mean the bull market is at its end or that a recession is imminent.
A stock market correction is natural. In fact, corrections are a natural and healthy part of the economic business cycle and by extension the market cycle. Since World War II, the markets have had 76 pullbacks of 5 to 10 percent, 26 pullbacks of 10 to 20 percent, eight pullbacks of 20 to 40 percent and three pullbacks greater than 40 percent, according to Ned Davis Research, says Brad Bernstein, senior vice president of UBS Wealth Management in Philadelphia. Over the long term, this averages out to about one correction every year.
One way to look at a correction is that it's the market pressing the reset button. Corrections help tamp the flame of irrational exuberance that may fuel bull runs by reminding investors the market doesn't move in only one direction. "Marke
ng]ts go up and down, not just up," says Greg McBride, chief financial analyst at Bankrate.com. A market correction is a friendly reminder to us all that we are not on a one-way ride.
What to do during a stock market correction? Stock market corrections allow traders to turn down the burner and reevaluate their current portfolio before their nest eggs burn. Because, really, too much of a good thing can be a risky thing.
Excessive gains can cause investors to become reckless. It's easy to forget that risk and reward go hand in hand when everything keeps climbing ever higher. This means it is also easy for portfolios to get out of balance during bull markets as certain assets are bid up higher than others. For example, a portfolio that began 2017 at a 50/50 stocks-to-bond ratio may have crept up to 55/45 stocks to bonds by the end of the year. Now may be the time to rebalance that portfolio back to 50/50 by selling stocks and buying bonds, Bernstein says.
Investors can use corrections to revisit their portfolio allocation and long-term goals. If you've been swept up in the stock market bubble, take a moment to ensure your portfolio is still in line with your long-term goals. "After volatility goes up or down, it's a great time to be rebalancing portfolios back to their original benchmarks," Bernstein says. He adds that rebalancing can be a particular beneficial reminder to "buy low, sell high" after market sell-offs when your emotions may be telling you to do anything but buy more.
Whatever you do, don't panic. The most important thing to keep in mind during a market correction is not to panic. When corrections occur, "it's best to stay the course, as long as your portfolio is invested according to your plan, and always rebalance after volatility," Bernstein says. While corrections may feel like the end of the bull market, they're just blips on the market's upward trajectory.
Markets "go up a lot more than they go down, so hang in there and consider buying more," McBride says. Like a runner catching his breath mid-race, a short-term pullback can lead to an even stronger bull market rally that follows.
Value investors may see "correction" and think "opportunity." As prices decline, companies that were previously overvalued can be snatched for cheaper prices following a correction. One investor's panicked sell-off could be another's bargain-buying opportunity. Economic fundamentals such as strong jobs and wage growth remain strong, McBride says, "so while there's no telling if the market will continue to correct or not, it's a good buying opportunity."