The stock market has been a means for many investors to generate wealth and achieve long-term financial goals. But, while indexes like the S&P 500 and Nasdaq 100 have comfortably outpaced inflation and rewarded investors over multiple decades, they have also weathered multiple stock market corrections.
“A correction is when a broad measure of the market — the S&P 500, for example — declines at least 10% but less than 20%,” states Dan Tolomay, chief investment officer at Trust Company of the South.
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Corrections can also happen to individual assets. A company may go through a correction due to a bad earnings report, an overheated valuation or other factors. Some stocks go through corrections while broader indexes like the S&P 500 continue to march higher.
Here’s what you need to know about stock market corrections:
— Stock market corrections are normal.
— Stock market corrections are healthy.
— Can a correction turn into a crash?
— How to plan for a stock market correction.
— Not all corrections offer buying opportunities.
— Stay focused on your long-term goals.
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Stock Market Corrections Are Normal
Most investors don’t like to see their portfolios drop by a correction-sized amount of 10% or more within a few weeks, but this is part of investing in the stock market. While all investors know that stocks don’t go up forever, a few good months can create a false sense of security.
Then, investors may end up panicking during a stock market correction and sell off some of their holdings to limit their losses. That’s one of the worst things to do during a stock market correction.
“While market crashes or downturns are never pleasant and cause fear and uncertainty, (they) offer great opportunities for the long term — the ability to pick up brand-name stocks with strong balance sheets and growth prospects, at fire-sale prices,” says Arvind Ven, CEO and founder of Capital V Group.
Some stocks lose value for reasons outside of their control. For instance, Meta Platforms Inc. (ticker: META) used to lose value if Snap Inc. (SNAP) released an unfavorable earnings report. Investors reasoned that if Snapchat performed poorly, then all social media stocks may endure the same fate.
Those short-term drops offered buying opportunities for long-term Meta investors. Even though investors believed Meta and Snap would release similar earnings reports, the companies are completely different. Meta has rapidly expanded its profit margins and tripled its fourth-quarter profits year over year. Meanwhile, Snapchat is down over the past five years and has decelerating revenue growth and persistent net losses.
Investors can spot buying opportunities within sector-specific and broad stock market corrections. As indexes fall, many quality stocks become available at a discount.
Stock Market Corrections Are Healthy
Stock market corrections keep investors in check. A lack of corrections can leave the stock market vulnerable to a crash because corrections pull back valuations to more reasonable levels.
A lack of corrections can also create a false sense of invincibility and cause investors to lose significant money. Many investors chased questionable electric vehicle stocks like Nikola Corp. (NKLA) and Workhorse Group Inc. (WKHS) in 2020 as Tesla Inc. (TSLA) stock continued to rev higher. Both of these corporations are now penny stocks that trade 99% below their all-time highs.
Can a Correction Turn Into a Crash?
All stock market crashes start out as corrections. This realization can prompt some investors to panic, but corrections are far more frequent than crashes. Most corrections reach their bottom after a few months, before the stock market regains momentum.
Investors should consider what broader events have triggered the correction. Some causes for a correction are more likely to turn into a crash than others.
“Sometimes, it can be events like war, the COVID pandemic, or events that have global repercussions. Stocks lose value significantly and quickly. That reminds us of the saying, ‘Markets go up like an escalator but come down like a high-speed elevator,'” Ven says.
Even then, the stock market has a history of recovering for long-term investors. The pandemic quickly turned from a correction to a crash as investors came to grips with how lockdowns would affect global commerce. The stock market only began its recovery once the Federal Reserve dramatically eased its monetary policy and initiated a historic economic stimulus program.
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How to Plan for a Stock Market Correction
A buy-and-hold strategy can get you through most corrections. Tolomay offers historical context that demonstrates how this straightforward approach has worked for long-term investors: “Since 1980, the S&P 500 has experienced an intra-year decline of -14%, on average. During that same time, the average calendar-year return has been 10%. In 2023, for example, the S&P 500 was off -10% from July 31 to Oct. 27 but finished the year up by 24%.”
Investors should assess their risk tolerance and where they are in their financial journeys. People who are approaching retirement usually want less volatility in their portfolios. These investors may want to lean toward mature blue-chip dividend stocks with reasonable valuations and high yields. These stocks can offer solid cash flow that can cover some of your living expenses.
Younger investors have more time to ride out market corrections and volatility. These investors can afford to put money into growth-oriented investments and wait for them to recover after they take a tumble. While age is a factor, investors must consider their patience and ability to stay even-keeled during market setbacks. If you are prone to selling off investments if they go down, a conservative portfolio may make more sense for you.
Not All Corrections Offer Buying Opportunities
The S&P 500 and the Nasdaq 100 have reliably recovered from each of their corrections. These indexes reflect the broader performance of the most established corporations. However, investors should dig deeper into an individual stock or fund before assuming that a correction offers a good buying opportunity.
Some stocks enter corrections due to significant cracks in their growth narratives. Etsy Inc. (ETSY) shined during the pandemic and had a few good years before the lockdown brought more demand to the company’s online marketplace. However, gross merchandise sales growth began to slip and recently decreased year over year.
Some corporations can turn things around after reporting bad earnings. Meta Platforms did just that in 2023 after a year to forget in 2022. Investors should assess whether the growth opportunities remain intact for an individual stock before buying shares. A stock can lose value due to a misunderstanding or because of a factor that isn’t important for the investment’s long-term viability.
Investors should take the same measures for a fund that doesn’t follow an established index like the S&P 500. Looking at a fund’s top 10 positions can tell you a lot about its portfolio diversification and risk level.
Some funds that perform well over several years rely on speculative growth stocks that can quickly collapse during broad stock market corrections. The Ark Innovation ETF (ARKK) is a recent example of this trend. The fund outperformed its peers for many years but is down by roughly 70% from its all-time high.
Stay Focused on Your Long-Term Goals
Individual stocks and funds perform differently during broad market corrections based on their opportunities and holdings. While outliers exist, the stock market has historically recovered from corrections.
Stock market corrections shouldn’t rattle long-term investors. The more time you stay invested in the stock market, the more you will experience corrections. Investors can adjust their portfolios and focus on low-risk assets to minimize their volatility.
Corrections can present tremendous long-term buying opportunities among reliable funds and stocks. Some investors get excited about corrections because it gives them the opportunity to lower the cost basis of their favorite stocks and funds.
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What Is a Stock Market Correction? originally appeared on usnews.com
