HOW TO HANDLE STOCK MARKET CORRECTIONS

What is a Market Correction?

A market correction is typically defined as a drop in stock prices of 10% or greater from their most recent peak. If prices continue down to the point where they are down 20% or more, it is then called a bear market.

Frequency of Market Corrections

·         Stock market corrections occur, on average, about every eight to twelve months.

·         On average, a market correction lasts about 54 days.

According to Fidelity (as of May 2010) Since 1926, there have been 20 stock market corrections during bull markets, meaning 20 times the market declined 10% but did not subsequently fall into bear market territory.

How to Handle Stock Market Corrections

If there was a way to “time the market” and figure out when it was going to go up, and then sell before a market correction occurred, well, who wouldn’t do that?

It seems there is plenty of information on the internet that suggests this is possible. Let’s think about this: if you had this skill, would you be writing articles on the internet... or sitting on the beach somewhere with your laptop, drinking a Corona and making money?

Most people lose money by trying to move their money around to participate in the ups and avoid the downs. This is a documented behavior which I discuss in Why Average Investors Earn Below Average Returns.

As a professional financial advisor, when we build a portfolio, we expect that one out of every four calendar quarters it will have a negative return. We control the magnitude of the negative returns by selecting a mix of investments that has either more potential for upside, which comes along with more potential for market corrections, or a mix that has less potential for high returns, and also less risk.

If you are going to invest in the market, it is best to understand that stock market corrections are going to occur, and it’s often best to just ride them out.

Think of it like going to an amusement park; you can’t get on the roller coast only for the up, and avoid the big downs. That isn’t how the ride works.

How to Control the Magnitude of Market Corrections You Experience

You can control the magnitude of the market corrections you might experience by carefully selecting the mix of investments you own.

First, you need to understand the level of investment risk associated with an investment. For example, in an investment with a Level 5 risk there is the potential you will lose all of your money. In an investment with a Level 4 risk, you might experience a drop of 30-50%, but you won’t lose it all. That’s a big difference in risk.

You can see a series of graphs that illustrate the amount of risk in different types of investments in Does Taking on Investment Risk Deliver Higher Returns.

I'd also suggest you read 4 Ways the Average Investor Can Manage Investment Risk.

Second, you need to understand how to mix these different types of investments to reduce the risk of your portfolio as a whole. This is a process called asset allocation.

It's important to reduce your exposure to significant market corrections as you near retirement. And once retired, you need to structure your investments so when market corrections occur, you are not forced to sell market-related investments; instead you use the safer portion of your portfolio to support spending needs during these times. This is covered in Withdrawal Rate Rules for Creating Income From a Portfolio.

Third, you must understand the risk-return relationship of investing. The potential for higher returns always comes with additional risk. The higher and faster the price of the stock market rises, the less the potential for future high returns. Just after a stock market correction, or bear market, the potential for future high returns in the market is greater.

The last thing to know; if you don’t want the potential to experience a market correction, it is probably best to avoid investing in the market all together. Instead, stick with safe investments.