How a Stock Market Correction Can Create Investment Opportunities
There are many recent concerns about the coronavirus. Plus, there’s worry about the Democratic primary elections. And an oil war with OPEC members. Stock markets have been tumbling. In fact, they have entered into correction territory. But what exactly is a stock market correction?
A stock market correction is a 10% drop in the market from its most recent peak. For example, let’s say the Dow Jones today is at 29,000. But over the next few months it falls 11% to 25,810. This would be considered a stock market correction.
Now, a market correction doesn’t necessarily mean the market was “wrong” about the valuation of stocks. Sometimes it is a reaction to unforeseen events in the broader market. For example: The coronavirus outbreak was an unforeseen event. There was no way to know it was coming.
About Stock Market Corrections
Does a stock market correction always indicate that the stock market is going to fall even lower? Not at all. In fact, there have been 10 corrections over the past 20 years. Only two turned into bear markets.
A bear market is a bigger fall than a market correction. A bear market means a stock market drop of at least 20%. And it is an indication of major stock market pessimism by investors.
Over a longer historical period, stock market corrections tend to occur about every eight to 12 months. So you’re likely to see one every year. This is no reason to panic. This is a natural economic occurrence.
And, generally, stock market corrections last about 54 days on average. If you wait it out a bit, it may very well be time to start pursuing more great investment opportunities.
What To Do When the Stock Market Corrects
When there is a stock market correction, people have a tendency to want to pull their money out of stocks and throw it into either better-performing investments or keep it in cash. But by this time, it is often too late. And this strategy can cost you even more money in the long run.
So how can you protect yourself from a bear market? The best way to do it is through portfolio diversification.
Portfolio diversification means you have your money in different types of asset classes. For example, you may have a mix of stocks, bonds, cash and gold.
The theory here is that when some markets – say, stocks – are performing poorly, other markets are likely to perform well, like bonds or gold.
This is what is meant by not keeping all of your eggs in one basket. If you put all of your money in one stock or one sector, you could lose almost everything if that investment does poorly.
But by diversifying well, high- and low-performing investments will support each other. Yes, this can reduce your overall return. But it also is the best protection you have against the risk of a bad investment or a down market.
Why Do They Occur?
On average, stock market corrections cause a decline of about 13% of the market’s total value. And it usually takes about 4 months for the market to return to its previous levels.
Why do stock market corrections occur? There can be a variety of reasons. Sometimes the various causes combine and make it worse.
At bottom, the prices of stocks and the value of the market as a whole are driven by supply and demand. This is like most economics. When there are more buyers than sellers, it causes prices to increase. And when the opposite is true, the market decreases.
This is helpful to know, but why are there suddenly more sellers than buyers? What explains this market driver?
There are a number of different factors that can cause sellers to outnumber buyers. These include:
- A prevalence of fear – When people are afraid that stocks are going to fall, this can turn worries into reality. Greed and fear are psychological motivators in the market. Greed leads to long bull market runs and fear leads to market corrections and bear markets.
- The Overall Economy is Doing Poorly – Broader economic factors, like inflation, job numbers and GDP, can have a major effect on stock markets. When the economy is not doing well, this can hurt the revenue and profit prospects of businesses.
- External Factors – External factors, like wars, trade wars, an industry collapse, environmental devastation or a global pandemic, can serve as a trigger for a stock market correction. The COVID-19 outbreak is one such external event. The current oil war between Saudi Arabia and Russia is another.
Can You Make Money During a Correction?
The answer is yes! Absolutely you can. You just need to identify the right investments in that environment.
While the stock market as a whole may be declining, there will always be some individual stocks that are performing well.
For example, here are the top 10 performing stocks over the last five days through Monday, March 9:
|Symbol||Name||5D % Chg||Last|
|VIPS||Vipshop Holdings Ltd.||35.74%||$17.13|
A portfolio comprised of just these companies could have earned you a fortune over the past five days.
So all is not completely bleak. As another example, check out the price of gold over the last three months.
If you are heavy in gold as part of all of your portfolio, it would have hedged against your losses and made you good money.
Moving Forward During This Stock Market Correction
The correction is happening. Stocks are declining. A bear market is a real possibility. The coronavirus and the oil war have led to tons of uncertainty.
But all is not lost. The idea is not to panic. There will always be ups and downs in the stock market. But this also leads to fantastic opportunities.
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Hang on. This stock market correction, too, shall pass. And in the meantime, it can lead you to opportunities that will make you quite a bit of money.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.