By the end of 2017, the S&P 500 had gained roughly 21% and pretty much anybody who invested in the market during that time frame made money. Then 2018 rolled around, we had a stellar January and then a big crash and rebound in the beginning of February. It seemed like the stock market couldn’t do anything but go up, and volatility (regular periods of ups and downs) seemed like nothing but a distant memory. As we quickly found out, however, this pullback was NOT the start of an economic recession or bear market, it was simply what’s called a stock market correction. This article answers a few common questions surrounding stock market corrections. Namely, what’s a stock market correction? Why do stock market corrections occur? And, most importantly, what’s the best way you can handle them as an investor?
What’s a Stock Market Correction?
A stock market correction constitutes a 10% decline from the market peak. Market corrections are typically quick, temporary occurrences, when compared to recessions which can be drawn out and result in bear markets. A correction, in our view, presents opportunities to invest at a discount. They’re typically driven by emotion and result in cheaper valuations of companies that have nothing to do with their intrinsic value. For long-term investors, this presents an opportunity to put cash to work.
Why do Stock Market Corrections Occur?
If you pay any attention to the news, you’ll hear all sorts of possible answers and explanations as to what caused the most recent correction in the market to occur, but the reality is no one truly knows. What we do know is the majority of investors don’t act rationally.
As we discussed in our post Understanding Behavioral Finance, academic theories such as the Capital Asset Pricing Model and the Efficient Market Hypothesis were thought to do a sufficient job of predicting and explaining certain events in the stock market. However, over the years it has come to light that these traditional theories only do a good job of explaining events when it is assumed that investors behave rationally. We know this just isn’t the case
Money and the relationship we have with it is highly emotional. Nobody enjoys the thought of losing money or going broke. When the stock market takes a tumble and the value of investors’ portfolios decline, people tend to freak out. They sell or they reposition all in the name of trying to “cut” losses despite the fact these losses only existed on paper before they sold. This causes a ripple effect in the market. It’s the definition of the idiom “jumping on the bandwagon”. As the stock market rises and picks up steam, more and more people get on board, but as soon as it starts to head in the opposite direction, everyone wants off just as quickly as they got on.
This “bandwagon” effect can explain corrections that happen quickly, and sometimes without fundamental explanation.
How to Handle a Stock Market Correction
It’s easy to panic and sell when the market declines, but doing so is counterproductive for long-term investors in relation to their financial goals. Every investor struggles with the challenge of making objective, rational decisions when it comes to investing. When we let our emotions control us and the decisions we make with our money, the results can be impressively harmful and disappointing. Understanding this dilemma is the first step towards making smarter decisions.
Being a successful investor requires patience and level-headedness. You need to stay focused on your long-term goals and simply ignore all the “noise” out there surrounding the markets. When a correction occurs, don’t sell, buy! Take advantage of dips to buy into the market at a discount. Warren Buffett said it best: “Be fearful when others are greedy, and be greedy when others are fearful.”
If you’re concerned about how your portfolio held up during a recent correction, or need help maintaining perspective when corrections do occur, schedule a free consultation with us today.