A stock market correction is defined as a steady decline in stock prices between 10% and 20% from their most recent high. The duration of a correction can vary depending on the underlying cause. Throughout history, there have been many corrections lasting from several weeks to several months. And in severe cases, they can lead to a bear market.

Usually, a correction will be announced after a leading stock market index, such as the FTSE 100 or S&P 500, has declined by the minimum 10% threshold. However, there are other terms used to describe periods of poor performance that are often misused.

• Stock Market Pullback – A short-term drop between 5% and 10% that usually occurs over a few days.
• Stock Market Crash – A rapid decline in stock prices greater than 20% over a short space of time.
• Bear Market – A prolonged decline in stock prices by more than 20%. In extreme cases, a bear market can last for years.

What causes a stock market correction?

A stock market correction can be triggered by various factors, including those that can also lead to a crash or bear market. Each market downturn has been relatively unique throughout history, but some initial catalysts have been similar.

Some of these factors include:

• Macroeconomic Conditions (inflation, interest rates, credit ratings)
• Natural Disasters
• Overinflated Valuations
• International Conflict
• Political Conflict
• Trade Wars
• Economic Uncertainty
• Low Investor Sentiment

Excluding 2022, the most recent stock market correction occurred in 2018. The S&P 500 and Dow Jones Industrial Average dropped by over 10% on the back of several brewing problems. In this specific scenario, the list of correction triggers included:

• Trade tariff hikes between the United States and China.
• Planned interest rate hike by the Federal Reserve to tighten monetary policy.
• Scrutiny of technology stocks regarding data privacy.
• High stock price valuations trading at twice their historical earnings multiple averages.
• US President Trump’s tax cut reform.

Are stock market corrections bad for investors?

While stock market corrections can be frustrating, they are actually pretty common events. In fact, on average, the stock market goes through a correction of some degree once every three to four years. It’s a normal part of the market cycle that allows valuations to cool off when they get too “hot”.

Corrections also serve as a valuable opportunity to invest in high-quality stocks at better prices. Often, novice and panicking investors will begin to sell their shares due to the sustained decline in valuation over several weeks or months.

This low investor sentiment can often push stock prices far below the fair intrinsic value of the underlying business. And for long-term investors, buying shares in top-notch enterprises at discounted prices is a proven recipe for long-term wealth generation.

It’s worth remembering that the stock market has a perfect track record of recovering from even the most severe stock market corrections and crashes throughout history. And this eventual upward momentum is almost always driven by investor sentiment steadily recovering as thriving businesses report solid earnings performance.

So are corrections bad for investors? It depends on the individual. For those dependent on their investment portfolio to generate income, they can be problematic. However, for investors with capital to spare, buying shares at discounted prices during a stock market correction can drastically accelerate the wealth-building process over the long term.

How often do stock market corrections occur?

The stock market cycle has some element of randomness. However, there has been a fairly consistent trend of corrections occurring every three to four years since World War II.

However, this time frame is more of a general rule rather than an accurate forecasting method. There have been periods far longer than four years in which a correction failed to materialise. And bearish investors attempting to time the market have often missed out on periods of impressive growth and wealth expansion.

Different catalysts have triggered each correction. And even when the conditions seem ripe for a stock market downturn, there’s never a guarantee that it will happen. That’s why most investment advisers often recommend clients prepare for an eventual correction but continue to invest consistently in the meantime.

How long does a market correction last?

Much like a stock market crash, the duration of a correction ultimately depends on what factors triggered it. Short-term problems typically get resolved relatively quickly. However, prolonged issues within the political policy can take longer to unwind.

Since World War II, the S&P 500 index has experienced 24 stock market corrections. Looking at these past events, the average loss in share price stands at -14.3%, with the decline taking place over an average of 133 days. In other words, stock market corrections typically last around four to five months.

How can investors prepare?

Predicting the timing of a stock market correction is almost always a fruitless endeavour. However, there are several steps investors can take to prepare or even capitalise on the next round of market volatility. These steps are identical to what investors should do in preparation for more severe stock market crashes.

• Build A Cash Buffer – One of the biggest mistakes investors make during a stock market crash is to sell shares after the price has collapsed. However, those who need money to cover living expenses may have no choice but to sell at a terrible price. This risk can be mitigated by ensuring sufficient cash is kept in reserve in a savings account.
• Diversify – Stock market crashes can hit different industries at varying degrees of severity. The risk of owning shares in the most heavily impacted industry is reduced by ensuring a portfolio containing a wide range of sectors. Similarly, allocating capital across a broad range of alternative asset classes, such as bonds and real estate, can further mitigate the impact of rapidly declining stock prices.
• Keep Spare Capital – With panicking investors selling off anything with a pulse, rare buying opportunities for top-notch companies may emerge. By ensuring some capital is kept in reserve, investors will have the money to capitalise on these investment opportunities.

What should investors do during a stock market correction?

Providing it doesn’t exceed an investor’s personal risk tolerance or stretch their financial position too thinly, investing in high-quality shares during a stock market correction is often the best move.

In the short term, this can deliver sub-par results as valuations can tumble on even the slightest bit of bad news. That’s why investing during volatility is inherently riskier. However, over the long run, providing the underlying businesses can deliver solid financial and operational performance, valuations are highly likely to recover before potentially reaching new heights.

Of course, there are never any guarantees. However, several buying strategies can be deployed to mitigate some of the risk factors of buying shares during a correction.

• Pound-Cost Averaging – Instead of investing all residual capital in one go, investors can break it up into smaller chunks and drip-feed it into the markets. That way, investors can buy more at an even better price if an undervalued stock continues to fall. Each time a lower price is paid, the average cost per share in an investment falls, reducing the impact of further price declines after the initial trade.
• Stop-Loss Orders – To protect against downside risk, investors can set up a stop-loss order. This is a set of instructions given to a brokerage firm that states that if a company’s share price falls below a certain threshold, the broker should sell the investor’s shares. This can reduce the impact of a severe valuation decline.
• Stop-Limit Orders – This type of trade works similarly to a stop-loss order. However, the key difference is that the investor doesn’t close out their entire position. Instead, they can specify how many shares should be sold if a stock price falls below a specified threshold. This also works in reverse. Instead of selling shares, a stop-limit order can be used to buy a specified number of shares once the stock price meets a specified price level.

The bottom line

A stock market correction is part of the natural market cycle. In fact, they serve a critical role in preventing prolonged artificially inflated share prices, enabling the market to be more efficient. While short-term traders need to be vigilant during these periods of weighted volatility, there is less concern for patient long-term investors.

Regardless, the best move any trader or investor can make is to not make impulsive decisions when the market enters correction territory.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.