Beginner’s Guide to Market Volatility

What you need to know about a stock market correction

Twenty/20

Even as the U.S. stock market hovers near a record high, some people on Wall Street are warning that a market sell-off could be coming.

It's been more than a year since the U.S. stock market endured a correction, or decline of at least 10% from a prior high. And these types of market events typically happen a little more than once a year, on average, according to data going back to 1928 compiled by Yardeni Research.

More than half of wealthy investors, for example, said in late 2019 that they expect a big market sell-off could happen this year, according to a UBS survey. Meanwhile, other people on Wall Street have pointed to similarities between the market today and in 2018 that could signal a possible correction ahead.

Here's what you need to know about a market correction and its effect on your portfolio.

What is a market correction?

Over the long run, the stock market trends higher. During shorter time periods, there can be wild fluctuations — but it's important to put such moves in context.

For a major benchmark like the S&P 500, it's very normal to see daily swings in excess of 1%. In fact, that's happened on about 27% of trading days in the last 20 years, according to FactSet data analyzed by Grow. When several declines of this magnitude happen in a string, or there's an even more notable decline in a short period, that's when you might start to see some of the following words thrown about to describe the movement of the markets. Here's what they mean:

  • Most experts define a correction as a market decline of at least 10% from a recent high, though people may also use it to refer to declines of smaller magnitudes (like 5%).
  • Once a market sell-off surpasses 20%, then it meets the criteria for a bear market.
  • A market crash refers to a sudden and very sharp drop in stock prices. It may happen as part of a correction or bear market — and could reverse very quickly, depending on the reason for the crash.
VIDEO1:5701:57
The difference between a bear market, a recession, and a correction

Video by Courtney Stith

How long do corrections last?

There are two time periods to consider with a correction: The amount of time it took for the market to decline, and the amount of time it took the market to recover.

Since World War II, the average correction for the S&P 500 has lasted four months, and it took another four months for the market to recover, according to analysis by CNBC and Goldman Sachs. And on average, this benchmark tumbled 13% before bottoming.

In the past decade, investors endured only six corrections, and these declines have happened as quickly as a span of 13 days (in early 2018) to as long as 157 days (back in 2011), according to data compiled by Yardeni Research. And the subsequent recoveries have taken anywhere from 70 to about 200 days.

Bear markets are far less common, but they're more severe in both how long they last and the extent of the losses. The average decline during the post-World War II bear markets has been 30% over a 13-month period, and it's taken the market another 22 months to recover.

By comparison, however, bull markets last years or even decades. The U.S. stock market currently is in the midst of the longest-running bull market in history, which began in 2009. And that's why it's important to remember that not only will the market bounce back from a sell-off, but will also continue its upward trajectory over the long run.

What happens during a market correction?

There's always a trigger for a market decline, be it on a day-to-day basis or over more sustained periods, as happens during a correction. Because investors become cautious about the pace of economic growth and potential gains in stock prices ahead, they're motivated to sell rather than to buy — and that sends the market lower.

The most common reasons for a market correction include:

  • Signs that the pace of economic growth is slowing
  • A shift in investors' appetite to invest in risky assets (like stocks) versus those considered safer (like bonds)
  • Geopolitical events (like war or military attacks) that might spook investors
  • Fear

During a correction, the value of your portfolio will drop, though it may be more or less than the broader market benchmarks. That's because the makeup of your portfolio is likely different than the S&P 500, for example. So, even if the S&P 500 falls 10%, your portfolio may only go down 8%.

How to prepare for and survive a market correction

Even though a majority of investors are aware of the risks associated with investing, they may not be comfortable actually experiencing those risks. Two-thirds of investors say they know portfolio declines of 10% are a normal occurrence — but even knowing that, 90% say it's important to protect their investments when volatility occurs, according to the results of a 2019 survey by Natixis Investment Managers of more than 9,000 individual investors worldwide.

You can prepare for a market decline before one occurs by managing the risks you take when investing. And one of the best ways to do so is with asset allocation, or the amount of your portfolio that's invested in stocks versus bonds, generally speaking.

When determining your asset allocation, the goal is to have a variety of investments to balance out potential risks of any individual one — what's known as diversification. And that means investing a portion of your portfolio in bonds, which don't typically move in lockstep with stocks.

Finally, it's important to accept that short-term ups and downs are a given when investing so that you can instead focus on the market's long-term merits.

By investing early, you'll benefit from compound interest, which helps your money to grow at a faster rate because you earn interest on your savings as well as interest on the interest you've earned. And by creating a habit of investing, and regularly adding money to your portfolio with a strategy known as dollar-cost averaging, you can take advantage of lower stock prices during periods when the market gets bumpy.

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