What is a stock market correction?

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The stock market has mostly been on a tear since it bottomed in March 2020 at the peak of pandemic worry. The S&P 500 index has almost doubled since then, rising 96.4 percent to an all-time high on July 14. But some market commentators are concerned that prices have risen too far too fast, leading them to suggest that a correction could be just around the corner.

But what exactly is a stock-market correction and what can you do about it? Here’s what you need to know:

What is a correction and what causes them?

A correction is a decline of 10 percent or more from an asset’s most recent high. For a stock that recently reached an all-time high of $100 per share, a correction would occur if the stock fell to $90 or lower. Corrections can happen in any financial asset such as individual stocks, broad market indexes like the S&P 500 or commodities. The S&P 500 would need to fall to 3,954 or lower for a correction to have occurred based on the July peak.

Corrections can be caused by a number of different factors and they’re difficult, if not impossible, to predict ahead of time. Short-term concerns about economic growth, political issues or a new variant of the COVID-19 virus all have the potential to trigger market corrections. These issues make investors fearful that their prior assumptions about the future might not be correct. When people are fearful, they typically look to sell stocks in favor of assets considered safer such as U.S. Treasury bonds.

Difference between a correction and a crash

A stock-market correction may sound similar to a crash, but there are some key distinctions between the two. A crash is a sharp drop in share prices, typically a double-digit percentage decline, over the course of just a few days. A correction tends to happen at a slower pace, therefore making the drop less steep than a crash would be. One of the most famous stock-market crashes happened in October 1987, when the Dow Jones Industrial Average fell 22.6 percent in a single day that became historically known as Black Monday.

Corrections are more subtle and are sometimes even thought to be healthy for rising markets because they help things from becoming overheated. Like their name suggests, they correct prices back down from a slightly elevated level.

Difference between a correction and a bear market

The difference between a correction and a bear market is in the magnitude of the decline. A correction is a decline of at least 10 percent, but less than 20 percent, while a bear market begins at a decline of at least 20 percent from a recent peak. Bear markets also tend to last longer than corrections because they tend to reflect an economic reality, such as a recession, rather than a short-term concern that may or may not materialize. The challenge for investors is that it’s very difficult to determine in real time whether a market is just in a correction or if it could become a bear market.

What should investors do during a correction?

For most people, the answer will probably be nothing. Corrections are to be expected as part of a long investing life and a short-term decline of about 10 percent isn’t much when you compare it to the return you’re likely to earn over decades. Trying to shift out of the market when you anticipate a correction is not a wise strategy because you’re likely to predict more corrections than actually occur. However, there are some ways to take advantage of corrections.

If you participate in a workplace retirement plan such as a 401(k) or make regular contributions to an IRA, the purchases you make during market corrections will earn higher returns than those made at higher prices. This approach is known as dollar-cost averaging and will help you take advantage of short-term declines.

If you happen to have extra cash available to invest, corrections can be a good time to put it to work because prices are more attractive. But be careful not to wait too long to invest or you might find yourself paying higher prices than if you’d consistently bought along the way.

Bottom line

Stock-market corrections happen occasionally, but long-term investors shouldn’t be overly concerned about them. Keep your focus on achieving your financial goals and try to take advantage of the decline in prices through consistent investing in your retirement accounts. Stocks are volatile, but that’s why they’re part of your long-term goals and not your near-term needs.

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