Understanding Market Corrections

For the past couple of weeks, many analysts have noted that the stock market is undergoing a “market correction.” But, for many new investors, this term “correction” can be confusing when we consider it in the context of our investments. If you are a new investor, you may be wondering, how does a market correct itself and what exactly does it mean when a correction occurs? How often do these corrections happen and what significance can they have on your portfolio?

First, major market corrections are relatively frequent events. They can occur as frequently as several times per year and as intermittently as once every few years. Basically, the frequency of these events depends on the total volatility of the markets at the time. However, these market corrections are different from normal market volatility, because they involve larger movements – defined as at least 10% of an index’s value from the most recent “high or low point” – to adjust for either an overvaluation or an undervaluation. This defined 10% is typically larger than average market volatility, so market corrections are seen as being slightly more “severe.” Thus, when investors discuss the most recent market correction, they are referring to the falls of both the Dow and the S&P 500 in early February, when each index dropped over 10% to “correct” from its recent high in January.

However, it is important to note that, while it is true that market corrections are typically downward shifts – meaning that markets are correcting from being overvalued – they may not necessarily indicate a long-term recession. Usually, corrections are last for much shorter duration than recessions. For example, if a market corrects downward from being overvalued, it typically tends to bounce back up slightly within several weeks of the correction’s lowest point. As we have seen since the latest market correction, both indexes have reverted slightly since. Thus, a market correction may not indicate a recession, as many new investors typically assume.

In fact, market corrections can actually be useful to investors in helping them to gauge their understandings of the volatility of the markets. Because normal market volatility occurs so often, investors are likely to notice when a stock becomes overvalued or undervalued. Then, by comparing the trends in certain indexes to those of other indexes, an investor can prepare himself or herself to best estimate the future volatility of that index – including the likelihood of the next market correction. This can help investors to make different stock-picking decisions.

After a market correction actually occurs, investors can evaluate the long-term trends to better understand whether the market will “rebound” after the correction – as mentioned above – or if it will drive itself towards a recession. This can be a strong indicator that can help investors in their decisions to buy and sell, as well. Many times, after a correction, investors can find stocks at “lower” prices than they typically sell for and may consider jumping in on these “bargain” prices if they believe that the market will rebound.

Finally, market corrections might be beneficial for new investors who are trying to gauge their levels of comfort with market variability. Of course, it is nice for all investors when the prices of their investments are steadily increasing (or becoming overvalued), but these market corrections can help bring investors back to a sense of reality. After a correction, investors will certainly better understand their abilities to deal with larger instances of volatility than they may typically be used to. This might help a new investor to structure his or her portfolio, helping him or her to choose which kinds of investments to buy.

So, all of this news about a market correction may sound frightening to new investors, but the truth is that market corrections can actually be “healthy” for markets – bringing their prices down to more reasonable levels. Like many of the indicators you read about, the more you understand market corrections, the more you might be able to use these instances to evaluate your own investments!