What is a Market Correction?
You’ve likely heard of bull and bear markets but what is a market correction and how should you handle it? A market correction occurs when the stock market falls 10% from its 52-week high. If you’re new to investing this may sound a little scary. Scarier still is that it often happens quickly, but you might be surprised to learn that a market correction is not always a bad thing.
How Often Do Market Corrections Occur?
There’s good and bad news, the bad news is that market corrections are not uncommon. They typically occur a little less than once a year. This can cause some stress which is why it’s generally accepted that you should not monitor your stock portfolio too frequently. Avoid checking it every hour, day, week or even year. Set and forget because the good news is that although market corrections are common, the stock market on average rises about 10% per year over the long run.
The Single Biggest Mistake That Investors Make
Investing is a wild ride of emotions. If you’re new to the game, you no doubt monitor your portfolio too frequently. If you’ve been around the block, you probably still monitor your portfolio too often. We live in a world of now now now, and although our brains know the market doesn’t always go up, it can be hard on us emotionally and mentally when the market moves against us. During these times, the single worst thing you can do as an investor is to sell your shares.
On average the market declines about 10% every 12-18 months, and it often feels like it’s for no reason. For those of you who weren’t around for the pullback of late 2018, it really didn’t have a catalyst. Stocks were widely considered overvalued at the time but one day they just stopped going up. The market peaked in August before falling sharply in November and then again in December. Late December the next rally began, and it didn’t end until August of 2019. The reason I mention this story is that the market dropped a tick under 20% within 2 months and nobody saw it coming. If you had pulled out anywhere near the bottom you would have then missed the 10% gain that occurred in less than a month from Dec to late January. The moral of the story is, don’t try to time the market.
What to Do During A Correction?
Having established that you don’t sell when shares are falling, what should you do?
Buy, of course, but why? The simple is that stock markets are mean-reverting. Let’s assume that stock markets are going to return 10% over the long run. If this year they return -15% then at some point over the next 30 years, they need to make up that 15% plus the 10% that they should have returned. By that logic, investing when the market falls allows you to achieve a return above the long-run average of the market. The even better news is that the further the market falls, the more significant the outsized return you can expect in future. So next time the market drops 10% buy and if it drops 20% buy some more.
Market corrections happen often and fast, and it’s essential to limit the emotional and mental impact from affecting your investment portfolio. Generally, the best approach is to simply not look at your holdings. Invest your money in something that doesn’t require regular attention like an index fund and then forget it exists.
If you learn that the market has taken a recent hit, the best thing you can do is to simply allocate more money to your next automated investment.
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