The potential of your investments increasing in value is an exciting prospect. But the fear of them plunging can be equally as daunting. Fortunately, these fluctuations are normal and often just reflect market corrections. Having an understanding of the implications for your portfolio can help you maintain financial discipline and prevent loss.
Stock Market Correction
A market correction is a sudden, yet temporary drop in the stock market of less than 20%. At this juncture, it may be hard to predict if the market will halt its slide and recover, or if it will continue to plummet and develop into a more serious crash. It's only once the market has recovered from this dip that it can be declared a correction.
The importance of understanding the potential consequences of a correction should not be underestimated. If left unchecked, a market drop could quickly become a bear market - defined as a prolonged period of decline in stock prices. By preparing for such an event in advance and having an action plan ready, investors can minimize their losses and make sure their portfolio remains resilient.
Is the beginning of a bear market indicated by corrections?
It is difficult to forecast whether a correction will escalate into a bear market (defined as a period when the market is down by 20% or more). Nonetheless, in history, the majority of corrections did not develop into bear markets. Out of the 24 market corrections since November 1974, only five of them evolved into bear markets, commencing in 1980, 1987, 2000, 2007, and 2020.
Understanding the Importance of Market Corrections
Market corrections can have a significant impact on short-term investors but usually affect long-term investors less. Long-term investors may ride out short-term market volatility as long as their portfolio is on an upward trajectory. Having a diverse portfolio, including non-cyclical or defensive stocks, can help you weather market slowdowns.
For those who attempt to "time the market," market corrections can present both opportunities and challenges. While it can be an excellent time to buy stocks at discounted prices, it's also risky because stocks may continue to decrease. It's generally better to rely on long-term growth rather than short-term gains.
Trying to predict market corrections is also difficult, even for experienced investors. That's why keeping your portfolio diversified and investing for the long haul is a wise approach. As you get closer to retirement, it's recommended to shift your investments towards more stable assets such as bonds to safeguard your portfolio from any sudden market downturns.
What Causes market corrections and How to Respond
Market corrections can be unnerving, but understanding what causes them can help ease your anxiety. Here are a few factors that can trigger a market correction.
External crises
External crises like the coronavirus pandemic in 2020 can trigger a market correction. These types of events can disrupt the global economy, leading to a slowdown in demand and supply chain disruptions. When businesses aren't able to operate as usual, stock prices can fall.
Industry or sector implosion
Sometimes, the collapse of a particular industry or economic sector can lead to a market correction. For instance, several tech firms saw their stock values crash in 2000 as the dot-com bubble burst. This sent shockwaves through the market, causing a broader correction. The housing crash of 2008 also had a similar impact, with the financial industry suffering significant losses.
Overheated market
An overheated market occurs when stock valuations are too high. Stock prices might go down somewhat if large institutional investors start pulling their money out of the market.This drop can trigger a selling panic among retail investors, resulting in a self-fulfilling prophecy. It's essential to remember that crises don't always trigger corrections, and a market can correct itself even without an external trigger.
Investor sentiment, economic indicators, and breaking news
Whether a correction happens or not might depend on investor mood, economic statistics, and breaking news.
For instance, if investors are upbeat about the economy, they could keep buying equities, which would raise prices.
On the other hand, if there is bad economic news, investors may panic and start selling their stocks, which will cause a market downturn.
How to respond to market corrections
The best way to respond to market corrections is to remain calm and avoid making hasty decisions. Corrections are a natural part of the market cycle, and selling during a correction can lock in losses. Instead, consider reviewing your portfolio to ensure that it's properly diversified. In addition, frequent portfolio rebalancing helps keep you on track with your long-term objectives.
Bottom Line
Market corrections can be caused by various factors. While they can be unnerving, they are a natural part of the market cycle. By understanding what causes corrections and how to respond to them, you can protect your portfolio and stay on track toward your long-term financial goals.
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