What Is a Stock Market Correction?
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The last two years have been pretty rough for the stock market. After a sharp downturn in 2022, stocks have been making an unsteady recovery in 2023. Over that time, investors have been hearing the term "stock market correction" more than they'd probably like to.
Stock market correction definition
A stock market correction describes a specific fall in value of at least 10% (but less than 20%) from a recent stock market high. Investors often use "stock market correction" to describe a drop in the market as a whole or within a specific index, like the S&P 500.
But individual stocks experience the same phenomena, and usually with much more volatility.
Stock market corrections vs. crashes, dips and bear markets
A dip is any brief downturn from a sustained longer-term uptrend. For example, the market may go up 5%, linger, and come down 2% over a few days or weeks.
A crash is a sudden and very sharp drop in stock prices, often on a single day or week. Sometimes a market crash foretells a period of economic malaise, such as the 1929 crash when the market lost 48% in less than two months, kicking off the Great Depression. But that’s not always the case. In October 1987 stocks plunged 23% in a single day, the worst decline ever, before roaring back over the next year. Crashes are rare, but they usually occur after a long-term uptrend in the market.
A bear market is a long, sustained decline in the stock market. Once losses surpass 20% from the market’s most recent high, it's considered to be a bear market.
» Read more about stock market crashes and how to handle them
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Why stock market corrections happen
At the most basic level, market corrections (and all types of market declines, for that matter) occur because investors are more motivated to sell than to buy. That’s simple supply and demand, but it doesn’t explain why investors are selling.
Investors are a forward-looking bunch. They’re trying to determine whether their investments will appreciate in value. Investors watch for signs, including news, rumors and anything in between, of how the market will move. It moves for many reasons, including because the economy is actually weakening, or based on investors’ perceptions or emotions, such as the fear of loss, for example.
While the reasons for a one-day drop may vary, a longer-term decline is usually caused by one or several of the following reasons:
A slowing or shrinking economy: This is a solid, “fundamental” reason for the market to decline. If the economy is slowing or entering a recession, or investors are expecting it to slow, companies will earn less, so investors bid down their stocks. On Sept. 13, 2022, markets had their worst one-day decline since June 2020, with all the major indexes falling 3.9% or more. The volatility came after the U.S. Bureau of Labor Statistics announced that inflation for August was at 8.3%. The news heightened fears that the Federal Reserve would announce a hefty rate hike later in the month to get inflation under control.
Lack of “animal spirits”: This old phrase refers to the surges of investor emotion and risk-taking during a bull market. As they see the chance for profits, people jump into the market, pushing stock prices up. When those animal spirits dry up? Watch out below!
Fear: In the stock market, the opposite of greed is fear. (And nothing is quite so good at stoking investors’ fears as a 24-hour news cycle that blasts how much the markets are going down.) If investors think the market is going to fall, they’ll quit buying stocks, and sellers will have to lower their prices to find takers.
Outside (and outsize) events: This miscellaneous category consists of everything else that might spook the market: wars, attacks, oil-supply shocks and other events that aren’t purely economic.
These reasons often work together. For example, as the economy overheats, some investors see a slowdown in the future and want to sell before a stampede of investors flees the market. So they sell, pushing stocks lower and dampening animal spirits. If the move down persists long enough, it may make investors fearful, sending stocks still lower.
At times like this it can be great to have someone by your side to steady your nerves, and that's one thing a financial advisor does well.
How long do stock market corrections last?
That's a billion-dollar question. If you knew that, you could time the market and become rich. Still, there are some guideposts for how long crashes, corrections and bear markets last. (We’ll skip dips for now; there are just way too many of them.)
Historically, corrections have generally lasted around four months on average.
Bear markets tend to be longer: In the three bear markets since 1987, the average decline has been 46.5% over 1.4 years.
But in contrast, the last three bull markets have lasted nearly nine years on average. Downturns tend to be short-lived, especially relative to uptrends.
What happens to your portfolio in a correction?
The S&P 500 index is the usual benchmark investors reference when they talk about “the market,” as it comprises the largest publicly traded American companies. But unless you’re invested exclusively in an S&P 500 index fund, your actual returns will differ from the market’s because you don’t own the same stocks in the same proportions as the index.
Gauging how you’ll fare in a market crash depends on the composition of your portfolio. The performance of individual stocks tends to be more volatile than that of the market. If the S&P 500 were to drop 10%, individual stocks in your portfolio could decline 5% or 15% or 30%. Some might even go up.
Finally, it’s important to understand that if a stock’s price declines by 30%, you’ll be waiting for an increase of more than 30% to recoup your losses. For example, imagine a $100 stock that declines 30%, to $70. That stock has to rise nearly 43% to get back to $100.
How can you prepare for a correction?
Knowing what’s happening when stocks are dropping is the first step in protecting yourself from the emotion and panic that accompany a financial loss. Learn how handle a stock market crash.
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