What Is a Correction?

What Is a Correction?

Let me explain what a correction means in investing. It's typically a decline of 10% or more in the price of a security from its most recent peak. This can apply to individual assets like a stock or bond, or to an entire index that tracks a group of assets.

You might see a correction last just briefly or stretch out over days, weeks, months, or even longer. On average, though, market corrections are short, usually between three and four months. As an investor, you should know that many factors can cause one—from broad economic changes to issues in a single company's strategy. The causes are as diverse as the markets themselves.

Key Takeaways

Remember, a correction involves a drop of 10% or more in the price of a security, asset, or financial market. These events can persist from days to months or beyond. While they hurt in the short term, they often prove beneficial by correcting overvalued prices and opening up buying chances.

How a Correction Works

Think of corrections as that inevitable event you know is coming but can't predict exactly when. You don't need to lose sleep over them, though. Based on data from sources like CNBC and Goldman Sachs, the average S&P 500 correction lasts about four months with a 13% drop before things bounce back.

If you're new to this or holding for the long term, a 10% dip in your portfolio might feel alarming, especially since corrections can strike without warning. But if you stay invested, it's just a temporary setback on the path to your goals. The market recovers eventually, so avoid panicking. For day traders or those with high leverage, however, a sharp correction in one session can lead to major losses.

Charting a Correction

You can't always predict a correction's start or end, or how deep it will go, until it's over. What you can do is study historical data to prepare. Analysts like me use charting to spot potential corrections by comparing market indexes—if one underperforming index mirrors another, it might signal trouble ahead.

Technical analysis helps here, tracking support and resistance levels to anticipate when a reversal could become a correction. When markets get overinflated, tools such as Bollinger Bands, envelope channels, and trendlines show where prices might hold or break.

Preparing Investments for a Correction

Before a correction hits, stocks might be performing well. But during one, many assets suffer due to the broader market mood. This can be your chance to pick up strong assets at lower prices, but weigh the risks—they could drop further.

To protect your portfolio, consider stop-loss or stop-limit orders. A stop-loss triggers a sale at a set price, though fast drops might mean it executes lower. A stop-limit adds a price range for more control. Monitor these orders regularly, as they can expire, and ensure they match current conditions.

Investing During a Correction

Not all stocks feel the same impact in a correction. High-growth, small-cap ones in volatile areas like tech often take the biggest hits. More stable sectors, such as consumer staples, hold up better since they deal in essentials and weather economic dips.

Diversification is key—include assets that move opposite to stocks, like bonds, or tangible ones like commodities and real estate. This setup can buffer your portfolio when equities falter.

Real-World Examples of a Correction

Corrections happen frequently. From 1980 to 2020, the S&P 500 saw 18 of them, with five turning into bear markets signaling economic trouble, while others reverted to bull markets indicating growth.

Look at 2018: In February, the DJIA and S&P 500 both dropped over 10%. Similar corrections hit in October, and by December, the S&P 500 fell 15% from its high. Markets rallied back, erasing losses by January 2019, and by April, the S&P 500 was up 20% from December lows.