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What Is a Market Correction?

The U.S. stock market plunged toward correction territory at the end of February, as investors began pricing in the economic impact of the coronavirus.

A ‘correction’ occurs when an individual asset or market falls 10% or more from its most recent peak. They can last days, weeks, months or even longer. According to Investopedia, the average market correction lasts between three and four months.

Corrections can be damaging in the short term as investors begin to worry about the health of the market and the value of their holdings. However, over the long term, corrections have proven to be good buy opportunities as markets typically rebound.

Under President Trump, the U.S. stock market has undergone two corrections: one in late 2018 and the most recent one in February. In the last 20 years, the large-cap S&P 500 Index has recorded 10 corrections, according to Yardeni Research. Of these corrections, only two turned into full-blown bear markets.

Let’s see the implications of market corrections.

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Correction vs. Bear Market

Whereas corrections are marked by declines of 10% or more from a recent high, a bear market requires a drop of 20% or more. The S&P 500 briefly plunged into a bear market on Christmas Eve 2018 before quickly recovering. The last full-blown bear markets occurred in 2007 and 2000. During those years, the index plunged nearly 57% and 49%, respectively, from its most recent high. As many of us know, the 2007 bear market preceded the 2008-09 financial crisis.

Bear markets require a much more sustained drop in asset values. Recoveries often take much longer and there’s no way of knowing whether the market will bounce back or continue lower. Whereas corrections can be considered healthy pullbacks, bear markets are often cyclical or secular. Cyclical bear markets can last for weeks or months, whereas secular bear markets can go on for years or even decades.

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Preparing for a Correction

For many investors, corrections are scary because they sometimes lead to full-blown bear markets, which can last years or even decades. However, as Charles Schwab outlines, “Nobody can predict with any degree of certainty whether a correction will reverse or turn into a bear market.”

That said, history teaches us a valuable lesson. According to Charles Schwab’s research, since 1974, only four corrections have turned into bear markets. This means most corrections present good buy opportunities for investors looking to increase the size of their portfolio.

Preparing for a correction can be difficult, but not impossible. Investors often employ stop-loss orders or stop-limit orders to equities or markets they believe could decline substantially in the short term. They also employ proper risk management strategies to ensure they’re not overly exposed to one particular company, sector or asset class. Allocating capital to ‘recession-proof’ sectors like consumer staples or utilities can also be helpful.

Diversifying into gold and government bonds can also shield investors from harsh pullbacks in risk assets like stocks. That’s exactly what we saw during the latest market correction. Gold spiked to more than seven-year highs while demand for government bonds also surged.

The Bottom Line

If history is any indication, market corrections create buying opportunities into high-value stocks. The downside can also be limited by employing stop-loss and stop-limit orders. But remember we can never fully predict whether a market correction will turn into a bear market, so it’s always important to exercise caution.

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