Understanding and Preparing for Stock Market Corrections

By Jane Young, CFP, EA

Stock market corrections are an inevitable part of investing. While the pain of losing money exceeds the exhilaration of making money, having an expectation that there will be years with negative returns keeps the loss in perspective. Corrections should not be a surprise; they happen regularly but are impossible to predict.

It is essential to plan for the likelihood of market corrections in your financial plan. To effectively incorporate them into your investment strategy it helps to fully understand corrections and have a historical perspective.

A stock market correction is a drop of 10% to 20% in a major market index such as the S&P 500. A serious market crash is a drop of 20% or more. A prolonged market crash is considered a bear market.

Since World War II there have been twenty-six market corrections with an average loss of 13.7% in market value with an average recovery time of four months. On average, stock market corrections occur every 1.7 years.

There have been twelve bear markets since World War II with an average loss of 32.5%. The average recovery time was 24 months. Not all pull backs in the stock market are associated with a decline in the economy. However, the recovery time is longer for bear markets accompanied by a recession. It took over four years to recover from the market crash of 2007 -2009.

Market corrections and crashes are unpredictable and do not follow a logical trend due to the endless array of random events and decisions that can impact the stock market.

A major decline in the stock market frequently follows a period of sustained growth or it may be triggered by negative investor sentiment, poor economic indicators, or political policy changes. An external crisis or a crisis in a specific industry or economic sector can also cause a market disruption. An unexpected event may result in investor panic caused by a fear that the market will continue to drop. This can create a vicious cycle that feeds on itself until other investors view the correction as an opportunity to buy at a discount.

Although market corrections are inevitable the stock market has always trended upward and every drop in the market has been completely erased by the favorable market that followed. Bear markets are short in comparison to bull markets. The S&P 500 has experienced almost three times as many days with gains as days with declines.

Rather than being fearful of market corrections, maintain a long-term perspective and view corrections as a normal part of the investing process. If you manage your portfolio in anticipation of periodic corrections, you can take advantage of opportunities to buy stock and stock mutual funds at a discount. A temporary drop in the stock market also enables you to harvest tax losses and minimize tax on Roth IRA conversions.