Investing > Stock Market Correction Explained

Stock Market Correction Explained

A smart trader reads stock charts; a wise trader knows the difference between a correction and a downward trend.

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Updated January 09, 2022

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Do you like watching your stocks take a sudden dive?

No one does, as this can be a very scary occurrence. But before you panic sell every stock you own, you should know that this could just be a simple stock market correction.

So, what’s the difference? 👇

Stock market corrections are a normal part of the life cycle of the stock market and are typically nothing to worry about. However, they can be dramatic, and it can be difficult to talk yourself into continuing to hold an asset that is taking a steep fall. 📉

Although you may be terrified of losing everything, experts frequently predict stock market corrections of 10-15%, especially following periods of high inflation. A stock market correction can even be a good thing in some of these cases as it helps to control the artificial inflation of stock prices. 

This means a stock market correction could be good for you as an investor in the long run. So before you freak out, keep reading to learn what a stock market is and what it means for you as an investor. 

What you’ll learn
  • What is a Market Correction?
  • The Effects of a Market Correction
  • What Causes a Market Correction?
  • Signs of a Market Correction
  • Stock Correction Example
  • How to Prepare for a Correction
  • How to React to a Correction
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is a Market Correction? 📚

A market correction is a brief downturn in the market as a whole, or in the price of a particular asset, that usually is somewhere within the range of 10-20% of the most recent peak. They usually last for a very short period of a day or two, but they can extend to 3-4 months in some cases.

This brief dip doesn’t occur for no reason, as it is a way that artificial inflation is controlled within the stock market. Therefore, as long as you don’t panic sell the minute the market begins to decline, typically market corrections are overcome by investors without any heartache.

It’s important to note that a market correction is characterized by being short, and the asset or market bouncing back fairly quickly. A market correction will never last longer than a couple of months. If it does, it is not a market correction but rather something known as a bear market. 🐻

Also, corrections never exceed 20% of a drop. If the drop is greater than 20% from the peak price of the product or market, then this is considered a crash, which is typically much more serious than a market correction. 

The dangerous aspect of this is, you often don’t know if the market is experiencing a correction, or a crash, until after it has ended. 

What are the Effects of a Market Correction?

As weird as it sounds, a market correction in the stock market, or in an asset, is the way the market prevents itself from crashing. Therefore stock market corrections tend to happen more frequently during a period of growth. 📈

Generally, the way a market correction works, is that an asset, or the market as a whole, has experienced a period of quick growth. Many investors have decided to purchase assets or stocks because of this period of quick growth.

Meanwhile, those who already held the asset have noticed the price increase, and have decided to sell their stocks to make some money. If this is done en-masse, the price of the stock will quickly drop.

This drop can be steep and must pass 10% to be considered a market correction, but historically will not go beyond 20% of the peak price. Before it can reach this low of a drop, the stock will usually rebound as people buy back into the asset, and head back towards the price it was at before it dropped. Sometimes, it will even extend beyond its previous high to an all-new high. 

2011 2020 corrections and crashes
Notable corrections and crashes between 2011 and 2020. Image by TradingView.

An asset or market typically will experience several market corrections, and there is no reason to worry unless the drop goes below 20% or the market correction extends past a short period of time. And this is when you should start to panic, as a crash or bear market could be imminent,  but more on what you can do in this situation later. 

What Causes a Market Correction? 🤔

Market corrections can be caused by many different events and occurrences. As mentioned above, a natural stock market correction will typically occur as investor interest in a product or asset changes and evolves. 

But market corrections can also happen because of external events, such as the market correction which happened in March 2020 as a result of the COVID19 pandemic. This market correction was massive, affecting the entire market.

Remember, market corrections can also happen just in certain sectors, or even just in a particular stock. These market corrections can also happen because of external events, such as the market correction experienced by the aviation industry following the attacks on the World Trade Center Towers on 9/11. 

Unfortunately, market corrections aren’t always this easy to predict, in fact, there are many times where a correction occurs simply because rumors begin in the investing world that a stock is overvalued. This can lead investors to sell and the price to drop. 

And there are other times where investors are sure that a particular news event will affect the stock market, and for whatever reason, the prices of stocks will keep rising without a correction. These are often the result of internal events, such as the announcement of a merger, or perhaps change in the organization of the company. 

Signs that a Market Correction is Coming 👨‍🏫

Although we’ve established that they are impossible to predict, there are a few signs you can watch for that may indicate a coming market correction.

The Broad Market Begins to Struggle 📊

As you invest in stocks, it can be easy to zero in on the few stocks you invest in. When these stocks are rising in price, you might feel pretty good about yourself. But this is when it is time to step back and take a wider look.

2015 market slow down
In 2015, the markets slowed down due to reduced manufacturing activity, low oil prices, and a weak global economy. Image by TradingView.

Even though your stocks may be rising, if the S&P 500 or Dow have started to stall, or maybe even begun to fall, this could be a sign that the market is overvalued overall, and is struggling. It is likely that a stock correction that may affect your particular stocks could be right around the corner. 

There Are Fewer Highs 🐂

During a bull market, the ‘highs’ experienced by the market or a stock should continually be climbing higher. If you notice that suddenly there are fewer highs, or the market seems to be ending at the same place each week, this is a sign that a correction could be imminent. 

The Lowest Low Has Been Passed 📉

Throughout the course of the day, a stock will experience smaller highs and lows as people buy and sell. This is even more true on a weekly scale. Thus, when a stock suddenly goes through the floor it had previously been bouncing off of, it has passed the lowest low, and it is likely that a market correction is beginning. 

There is a Triggering Event 🕵️‍♂️

Most market corrections don’t just happen, they need an external or internal event to kick them off. Sadly, most of these events are sudden, such as the attacks of 9/11, and are impossible to predict for the wide market.

For those investing in a particular stock, if you see the above three signs, then hear rumors of a merger or acquisition, this could be the triggering event that will lead to a market correction within the asset. 

Remember, however, that these are just signs, and even if you see all four of them, this isn’t a 100% guarantee that a market correction is coming. But if all of these signs are present in the market, then you may want to brace yourself as it is likely that a market correction is coming. 

Stock Correction Example 📘

Corrections don’t just happen to whole markets—it is much more common to see a stock- or sector-specific correction. For instance, Amazon is a popular stock that underwent a major correction in which it lost 14% of it’s value in 2021.

The correction began on July 5th, 2021 when the value of Amazon stock (AMZN) began a fall from $3,719 per share to $3,199 per share. This correction was approximately 14% of the stock’s value at the peak of $3,719. It took a few days for this correction to happen, and the stock would reach its lowest point on August 16th, 2021.

You can see this on the chart below.

AMZN correction of mid-2021
The AMZN correction of mid-2021 is an example of how one overvalued stock’s correction can be triggered by a single piece of news. Image by TradingView.

This is a true correction as the fall in value did not exceed 20%, and the correction only lasted about 40 days. Then the stock began to recover and head back towards it’s previous high. 

This stock correction happened right as people began to receive their COVID19 vaccine, thus analysts assume that it occurred as people began leaving online shopping to go shopping in person because they felt safe again.

This also explains why it didn’t quite reach its peak again for a while. Although people quickly returned to their online shopping ways, there were many people who simply decided they preferred in-person shopping better. 

Plus, it is highly likely that much of this market correction happened because of a natural sell-off of stock that occurred as Amazon reached one of its highest points in history. Investors simply felt that there was no way the stock could go any higher, and therefore they began to sell, starting a correction for the stock. 

How to Prepare for a Correction 🏗

Market corrections sound pretty scary. And they are, which is why you should learn to properly prepare for one that may come your way, as market corrections are part of being invested in the stock market. 

Diversify 🗃

The number one way to prepare for a stock market correction is to be sure your portfolio is diverse. This way, if a correction hits some stocks (like AMZN), you won’t be completely decimated. 

This is why many investors have bonds and other non-stock assets in their portfolios. The rate of return on these assets isn’t great during a bull market, but they can be a great hedge when there is that inevitable market correction. 

Be Careful of Volatile Stocks 🚧

This goes along with diversification, but if your portfolio is filled with volatile stocks, it will be rough on you when a correction hits. 

Therefore, you need to diversify both in the assets you hold, as well as in the specific stocks you hold as well. So if your portfolio has a few stocks that are quite volatile, consider trading them out for stocks that tend to be less volatile, such as consumer staples and healthcare–as these stocks tend to weather corrections better than other more volatile options. 

Invest in Recession-Proof Assets 💰

Did you know there are some assets that actually tend to perform well in a recession? It’s true. Adding some of these to your portfolio in advance can really help post its overall performance when that inevitable correction does hit. 

Recession-Proof Assets
Gold has historically gone up in price as a consequence of stock market corrections and crashes. Image by TradingView.

There are multiple kinds of recession-proof assets, and that depends on what kind of recession it is. If it is an inflationary recession, gold usually does the trick. If it is a deflationary period, cash investments and debt will do better.

Take a Look at Your Liquidity 📃

The last thing you want, besides a non-diversified portfolio, is one that you cannot pull assets out of even if you wanted to. There are some investments, such as real estate, that can be difficult to sell in a market correction. For this reason, you need to take the time to evaluate the liquidity of your portfolio as well.

While it’s okay to get stuck with one asset during a market correction, you don’t want to get stuck with your entire portfolio if the market really begins to tank. Thus, take a look at your portfolio and ensure it has some highly liquid stocks that you could sell if times got dire. 

Prepare Yourself Mentally 🗓

Besides just prepping your portfolio for some carnage, you also need to prepare yourself mentally. This is because you may be tempted to sell the minute you see your stocks take a slight dip. 

Keep in mind that most corrections are temporary and that the asset is likely to rise again back to its peak price, if not higher. You should go into investing with this mentality so that you don’t panic the minute a correction hits and sell off a stock that you later regret selling. 

How to React to a Correction 👷‍♂️

Your worst nightmare has just happened, and you believe the market has entered a correction–now what?

First of all, it’s important not to panic, and to remember everything you’ve learned in this article so far. Panic selling won’t help your bottom line or your portfolio. Instead, it’s time to start looking at some of the options you have during a market correction.

Now, you don’t have to do every option on this list. You could decide just to do one, or maybe a couple. These are just some ideas of what can be done to help the sad state of your portfolio during the inevitable market correction.

You additionally should take some time to analyze why the correction is happening to the market or the market of your particular stock. This can help you better understand if you should expect a further decline, or if it is likely that the stock will experience a simple correction then continue its growth. 

You can see an example of this in what happened to the oil companies during the COVID19 pandemic. Many of them experienced a correction as people were forced to stay home. But this doesn’t mean that people sold their cars. Thus, the minute things began to open again, the stock rallied and began to climb once again. 

Wait it Out ⏳

One option when it comes to a market correction is to simply wait it out. As you’ve seen, market corrections can be quite short in nature. There is a chance that within a month or two, your portfolio will be right back where it started.

The great recession and covid crash
The housing market crash in late 2007 brought a recession that lasted about 5 years, whereas the stock market rallied just 6 months after the COVID-19 crash. Image by TradingView.

But, there is also the chance that the market correction could turn into something worse, such as a crash or the dreaded bear market. When this is the case, you will likely regret not having taken action when you could. 

Buy More Stocks 💵

The good news about a market correction is that it makes stocks cheap (including your own so don’t be too happy about it). So this is a good time to perhaps buy some stocks in an industry that you previously considered too expensive. 

It’s important to note that these stocks you are buying could fall further in value before the correction ends, meaning you should only purchase stocks that you think will do well in the long run and that you plan to hold for an extended period of time. 

Use Leverage to Buy Stocks 💳

There is something really positive about a stock correction, and this is that if you can use leverage to buy stocks—trading on margin, you can acquire stock for very cheap. Basically, this means taking out debt from your broker using your portfolio as collateral—but you don’t need to sell anything.

This is a very risky tactic, however, and you will need to tread lightly. You also should work to manage your risk by using your leveraged funds to buy assets that will do well in a recession, in case the market continues to slump. 

For example, this could be a good time to buy gold, which has historically performed very well during a bear market or recession when the public loses faith in the stock market. This doesn’t mean you have to buy some gold bars to put under your bed as there are various gold stocks that follow the performance of the precious metal. 

Review Your Portfolio 🔍

Surprisingly, a stock market correction is a great time to review your portfolio. How did it hold up? Are there things you would do differently next time around? Do you like the amount of risk you were exposed to?

Although a correction is not the best time to begin making changes, it is a good time to plan for future changes and review what did well in your portfolio and what did not. Maybe your stocks fell further than you thought, and next time around you would like to purchase more recession-proof stocks. 

Again, it is not the best time to sell something you are unhappy with in your portfolio. But if you do see a cheap stock that you’ve always wanted to own, there is no time like the present to buy it!

Don’t Get Caught Up in the Media 📰

The media is there to sell papers and online articles. This means that during a stock market correction, they will be going crazy with tales of woe and recessions. 

Don’t let these reports get to you. Continue to perform your own research on stocks and make decisions based on what you think is going to be best for your portfolio. 

Conclusion 🏁

There’s no doubt about it, stock market corrections are scary for even the most seasoned investors. But as long as you understand how a market correction works, and have properly diversified your portfolio, it is highly likely that you will come out of a market correction no worse for wear.

Just don’t forget that market corrections are temporary, but they could mean that worse times are coming. So if you do find yourself in a market correction, be sure to evaluate your options carefully and invest in stocks and assets that would do well during a possible recession–as you never know what may come next!

Stock Market Correction: FAQs

  • What is a Technical Correction?

    A technical correction is another word for a market correction, as it refers to a market that experiences a drop in value between 10-20% for a short period of time. 

  • Where Should I Put My Money Before the Market Crashes?

    When you are worried about the stock market crashing, it is usually safe to invest in recession-proof assets such as bonds and gold as they tend to go up after crashes. 

  • What Stocks Should You Buy in a Recession?

    During a recession, it is considered safe to buy bonds, as well as stocks that tend to weather the tough times, like utilities, consumer staples, and blue-chip companies–as these are very relevant even during economic downturns. 

  • Can Stocks Go to Zero?

    While rare, it is entirely possible that a stock can go to zero. This usually happens if a company goes under and closes business for good. 

  • What is the Difference Between a Correction and a Crash?

    A stock market correction is defined as a fall of prices between 10-20% of the stock's peak price. If the price of the stock declines by more than 20%, this is known as a crash. 

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