There is nothing more exciting than seeing your investments bring in money. At the same time, it is disheartening to see the market take a tumble. 

In the present world of finance, it is common to see ups and downs in the market. Many of these dips are stock market corrections. But what is a stock market correction? 

Let us better understand what it means and how you can better protect your wealth.

What is Stock Market Correction - Table of Contents

What Is Stock Market Correction?

A stock market correction is a small dip of 10-20% in the market or in an individual stock that happens to correct an artificially inflated stock price and unsustainable growth. This stock market correction can last from a few days to a few months.

An asset or market can fall into a correction briefly or for a few days. But, the average market correction is mostly short-lived and lasts 3-4 months. Investors, analysts and traders use multiple charting methods to predict and track these stock market corrections. Multiple factors can trigger a correction, such as large-scale macroeconomic shifts, single company management issues, to the pandemic.

How Does Stock Market Correction Work?

Now that we know what a stock market correction is, let's look at how it works. 

Stock market corrections are unforeseen situations. All analysts, investors, and portfolio managers know that it is lurking around the corner, but no one knows when it will appear. So, it is better not to lose sleep over it. 

According to a 2018 report from CNBC and Goldman Sachs, the average correction for S&P 500 was only 4 months, during which the value fell by 13% before recovering. But, it is easy to see why a new investor might worry about a downward adjustment of more than 10%. No one can correctly predict when a stock market correction will happen or how long it will last. But, for those in the market with long-term plans, a correction is a small pothole in the entire drive to savings. 

But, when a dramatic correction occurs during a 1-single trading session, it can be disastrous for day traders or those who over-leverage. These traders see significant losses during the corrections. No one can predict when the correction starts and ends or how drastically the prices will drop until after it is over. What investors and analysts can do is look at past corrections data and plan. 

Examples of Stock Market Correction

Now that we know what a stock market correction is let's look at some real-life examples. Market corrections have happened fairly often. Between 1980 and 2022, the S&P 500 saw over 18 corrections. Five of these resulted in bear markets, which indicates an economic downturn. The others transitioned back into bull markets that showcased indicators of economic growth. 

In February 2018, two major indexes - the S&P 500 and the Dow Jones Industrial Average (DJIA), saw corrections that dropped by more than 10%. In October 2018, Nasdaq and S&P 500 saw corrections as well. But both times, the market bounced back. 

But the market saw another correction on December 17th, 2018. DJIA and S&P 500 dropped over 10%, and the S&P 500 fell over 15%. The decline continued into early January with the prediction that the USA has ended its bear market phase. The markets began to rally after this, and by April 2019, S&P was up by 20%. 

How to Identify Stock Market Corrections?

When trying to understand what is stock market corrections, it is imperative to understand how to identify them. By using market analysis, corrections can be projected by comparing one market index to another. Using this method, analysts can discover underperforming indexes that can be followed closely by other underperforming indexes. A steady trend of these might signal that a market correction is coming up. 

Technical analysts review price supports and resistance levels to predict when a market reversal or consolidation can turn into a correction. Technical corrections happen when assets or the market get over-inflated. Analysts use these charts to track the changes in the market, index or asset over time. Some tools that determine where to expect such price support and resistance levels include trendlines, envelope channels, and Bollinger Bands. 

What are the Effects of a Stock Market Correction?

When a stock market correction occurs, the market dips itself to avoid a market crash. This occurs during the total growth period. Based on historical evidence, most market corrections have not gone beyond a 20% decline, resulting in a bounce back to a normal market or even a bull market. 

But, a market correction can change into dire consequences if the decline exceeds 20% and lasts longer. The market then shifts into a bear market. This decline in the market is accompanied by economic stagnation and increased unemployment. In some cases, this leads to recessions. 

It is important to understand that the term stock market correction means the effect on the market as a whole. But all stocks do not react to these corrections equally. High-growing and volatile stocks tend to be highly reactive, whereas non-cyclical stocks like defence do not fall that far.

When Was the Last Stock Market Correction?

The S&P 500 is currently in a state of the stock market correction. This index's last all-time closing high was 4796.56 on January 3rd 2022. Since then, the benchmark index has declined to 17%. This means that it is in the stage of correction. 

How to Prepare Investments for a Correction?

Before a market correction, individual stocks can be in a strong stage. But during a correction period, individual assets can perform poorly due to the market conditions. Corrections are the best time to buy high-value assets at discounted rates. But, investors need to weigh the risks involved with such purchases, especially if they see a further decline when the correction continues. 

Protecting investments against corrections is difficult but possible. Investors need to set stop-loss orders or stop-limit orders to deal with a drop in equity prices. Stop-loss orders are automatically triggered when the price level hits a pre-set limit set by the investor. But the transaction might not get executed when the prices are falling fast. 

The second stop order sets specific target prices and an outside limit price for the trade. A stop-loss guarantees the execution, whereas a stop-limit guarantees the price. Stop orders need to be regularly monitored. This ensures that they reflect the present market scenario and true asset value. 

How to Plan your Investment During a Correction?

Stock corrections are known to affect all equities, but in some cases, they hit some harder than others. High-growing stocks like technology and small-cap ones tend to have the strongest reactions. Other sectors have more buffering. For example, consumer staple stocks tend to be business cycle-proof because they involve retailing or the production of necessities. So, these stocks still perform well when a correction happens or moves into an economic downturn. 

Diversification offers protection if it involves the assets or stocks that perform opposite to those being corrected or influenced by multiple factors. Other investment vehicles and bonds are a traditional counterweight to equities, whereas real assets like real estate are another opposition to assets like stocks. 

It can be quite challenging to plan investments when market corrections occur, and when a 10% drop happens, it may hurt specific investment portfolios. But, most investors and analysts will agree that market corrections are good for the market. For the market, corrections help readjust and recalibrate asset valuation that might be high. For investors, corrections offer the option to take advantage of discounted asset costs and a valuable lesson on how quickly the financial market can change. 

Pros of planning your investment during a correction:

• Helps create buying opportunities for high-value stock. 
• Helps mitigate losses by stop-loss/limiting orders.
• Helps calm an overinflated market.

Cons of planning your investment during a correction:

• This leads to the creation of panic and overselling. 
• Hurts short-term investors and leveraged traders.
• Can turn into a recession.

List of Stock Market Corrections in India

This is the list of the stock market crashes that took place in India: 

• The crash of 1865
• Crash of 1982
• Crash of 1991
• Crash of 1992
• UPA 1 election crash of 2004
• Crash of 2006
• Crashes of 2007
• Crashes of 2008
• Crashes of 2009
• Crashes of 2015 
• Crashes of 2016 
• Crashes of 2018 
• Crashes of 2020.

Do Corrections Mark the Start of a Bear Market?

No one can predict with certainty that a correction will turn into a bear market (a period where the market is down by 20% or more). But, historically, most stock market corrections have not turned into bear markets. There have been over 24 market corrections since November 1974, and only 5 turned to bear markets - 1980, 1987, 2000, 2007 and 2020. 

All investors want to see a state of a constant bull market. But sadly, that is not possible. Bear markets will occur periodically in an investor's lifetime. But it is helpful to keep a watch out for them. Since 1966, the average bear market has lasted around 15 months, far shorter than the average bull market. These situations begin and end abruptly and with such a quick rebound that they are difficult to predict. Long-term investors should stick to their course instead of pulling money out of the market. 

Conclusion

If you are still wondering what is a stock market correction, then know that it is a natural movement of the market. But, if there is one rule you need to follow when investing, it is not to make any impulsive decisions based on the market rise or decline. 

Understanding what a stock market correction is and how it works will help you understand the nature of your investments so that you can efficiently manage them. 

Some investors use the information of stock market corrections to time the market, but you will benefit more by using the information gained to remain steadfast when the market takes a hit. So, have patience regarding the stock market and make sure you have a diverse portfolio to balance your gains and losses.