Don’t Panic! The Dow, S&P 500, and the Nasdaq all just dropped 17% over the course of a week, seemingly crushing any significant gains you have made in your investment portfolio over the last 3 years. As an investor, it’s natural to feel scared and anxious during a market correction. After all, the pain of a loss is twice as intense as the feeling of a gain. However, this loss is temporary, and it doesn’t even have to be too severe if you are taking the right steps with your investments during a market correction. Below, we show you exactly what those steps are.
What is a Market Correction?
A Market Correction is defined as a drop in price of an index or market by 10% – 20%. If the market drops below 20%, then that is considered to be in a bear market. Market Corrections happen to the market about every three years. And while these market corrections feel like a gut punch to your financial well-being, they are actually a healthy part of market growth and help realign stock price and underlying value. Another reason not to worry too much of a market correction is that they are usually short-lived, and they are usually followed by a sustained period of growth.
Market Corrections occur for a variety of reasons. A stock market correction can occur within an index or industry like what occurred in the Teach industry in early 2021. During the pandemic of 2020, Tech and innovation stocks went on a meteoric rise. Investors large and small piled into Tech and valuation soared. Big Tech like, Amazon, Google, Microsoft, and Facebook grew so much that they actually became 23% of the total weight of the S&P 500. Meanwhile, smaller innovation stocks that had yet to even turn a profit saw their stock prices grow by 200% and 300%.
These soaring valuations were caused by upward pressure from momentum. People saw these stock prices climbing and continued to buy sending the price of the stock much higher than its intrinsic value. When the dust settled, this industry corrected itself, and realigned price and value in much of tech.
Stock Market Corrections can happen at an entire market and index level as well. Larger, Macro events such as COVID-19 or the 2008 housing crisis can have a blanket effect on markets across the board.
So, even though market corrections happen occasionally, there are steps you can take before and during a market correction that can keep your investments safe and even be prepared to take advantage of the ensuing growth.
What to Do Before and During a Stock Market Correction
A lot of the moves you make during a stock market correction depend on how much experience you have as an investor. However, for the majority of retail investors, taking three steps before a market correction occurs can save a lot of aggravation and loss in capital.
3 Steps to Take Before a Correction
- Make sure you have a Balanced and Diversified Portfolio – If you are overloaded in stocks or a particular sector, a market correction is going to feel a lot more severe. However, because market corrections are more likely to happen within a sector, industry or commodity, diversifying your investments so they are uncorrelated from each other, will limit your losses during the correction. Your portfolio should have a good mix of stocks, bonds, industries, commodities, and other assets. Overloading your stocks in sectors that are speculative or have been on a recent run, like the tech example we noted, can set you up for major losses when the correction comes.
- Understand Your Financial Goals – Understanding why you are investing is a crucial step to investing success. Mapping your financial goals and understanding what it’s going to take to achieve them will help you manage your actions during the stock market correction. If your financial goals are long-term, then you shouldn’t have to worry too much about losing money. If your goals are primarily short-term, then you may need to take some action.
- Don’t Try and Time the Market – As hard as it is not to, don’t time the market. People are naturally reactionary, so the first day of a big correction, people will pull their money out of stocks. Pundits are always saying the next correction is right around the corner, so being fearful and pulling your money out of the market can often times lead to missed gains. Buffet’s quote of “Be Fearful when others are being greedy, and be greedy when others are being fearful,” holds a lot of weight during times of market corrections.
3 Steps to Take During a Correction
The actions you take during a market correction depends heavily on the amount of investing experience you have and what you are trying to accomplish. That being said, here are 3 steps you can take during market correction that can save you worry and money.
- Ride it Out – Below is a picture of the DOW Jones all time. During the past 100+ years, the market has recorded 54 corrections and bear markets. The longest bear market lasted 929 days, but as you can see, we are always moving up and to the right. Riding out the market correction is going to be your best bet. If you are confident your portfolio is well diversified and you have a strong understanding of your financial goals, then fear not. Sooner than later, you will be riding high again.
- Buy The Dip – As we mentioned, any correction is typically followed by a sustained period of growth lasting around 3 years. Market corrections can be outstanding opportunities to buy quality stocks at discount prices. Market corrections that occur at a macro level like the COVID-19 or housing crisis of 2008 present even greater opportunities to buy the dip since its more than likely these events have dragged down the entire market and produced stocks whose prices are way below value.
- Play Defense – Defensive sectors such as healthcare, consumer staples, and Utilities are excellent plays during times of market correction, whose prices can soar while the overall market lags. These stocks are typically “boring” but can burst during the corrections. Healthcare stocks such as Cigna and Consumer Staples stocks such as Mondelez, get higher ratings on Wall Street as Defensive stocks to buy if a correction occurs in 2021.
Seasoned investors and traders may even try to buy a put during the correction. This option strategy can be exciting but because the timing of the correction is so hard to tell, traders can stay in the trade too long and lose their investment as the market rebounds. If you don’t have trading experience, taking the time to learn to trade options is crucial to investing success.
Summary:
- Stock market corrections are a normal part of market growth and investors should not panic
- Market corrections are defined as a 10% – 20% drop in a market, index, or sector
- If your investments are properly diversified, you understand you financial goals, and don’t try to time the market, you will be in good shape during a market correction
- 3 things you can do during a market correction are ride it out, buy the dip, or play defense in stocks such as healthcare, utilities, or consumer staples
