What Is A Stock Market Correction?

Experts refer to certain stock market declines as “corrections”. But what exactly are corrections and what is the difference between a correction, pullback and bear market? Glad you asked.

When the S&P 500 index declines 10% to 20%, it’s known as a market correction. If the market drops less than 10% it’s called a pullback. And if the market falls more than 20% it’s labeled a bear market. What do these terms have in common? And what should you do about it?

Experienced investors know that dips and drops are par for the course. If you put money in the market you have to be ready for tough periods. But just how often do these hiccups happen? Market research firm Birinyi Associates of Westport, Conn did the digging and came up with the data.

They found that between 1962 and 2011, the S&P 500 shed 20% or more on 9 occasions. That’s just about once every 5 plus years. During that same period, the market fell into a correction (losing 10% to 20%) 16 times – or once every three years. And even during good years, the market has its rough spots. On average, the market drops a little over 7.5% during the year even when the market ends in positive territory for the year.

 

What Should You Do With This Information

I believe this data can help you and I gain better perspective on our investing. I’ll get to that shortly. But I don’t think it makes sense to have a fixed response to “pullbacks”, another for “corrections” and yet another for “bear markets”. The labels the pundits ascribe to market movement isn’t that helpful.

Neal’s Notes:   The critical piece is to make sure you check your own “risk pulse” once in awhile to see how much risk you are really comfortable taking – and compare that to the risk you actually have in your portfolio.   Here’s a tool that can help you do just that.

What difference is there between a 19% “correction” and a 20% “bear market”? Not much. And a 2% loss is very different from a 9% loss. Why are they both are called “pullbacks”? So the first thing I suggest you do is forget about terminology – it won’t help you make more money or protect your account any better.

What can help you as I said above is to have perspective. Market drops happen all the time. You can either hold through these difficult periods or use a market sensitive approach to try to minimize the damage. Either way, there is no guarantee of better results. The buy and hold approach works well for some people and for not for others. A smart market rotation style can be great but it’s not foolproof. Using any particular approach you probably won’t beat the buy and hold investors every year.

If you look at the S&P 500 you can plainly see that it has a history full of pullbacks, corrections and a few bear markets as well. None-the-less, long term investors who are able to stick with it, have done nicely. This is no guarantee of future results but it helps maintain perspective.

Corrections happen all the time. We might be in one now. Or it might start tomorrow. It’s impossible to predict friend.

Instead of trying to become a fortune teller, pick an investment strategy you feel comfortable with and stick with it. If you are a buy and hold investor, don’t get spooked. If you shift your positions as the current market changes, rely on your system to adjust your holdings. The one thing I strongly caution you against is to react emotionally to a pullback, correction or even a bear market.

Are you concerned about market corrections? Why or why not?