What is a market correction?
A market correction is when a stock market or index falls by 10% or more from its most recent peak.
Market corrections come in different shapes and sizes. Sometimes falls are evenly spread across global stock markets. Other times sell-offs are more focused on a particular country or sector. In most cases, the reasons behind the correction determine where the impact is felt the most.
What causes a market correction?
There isn’t always a rhyme or reason as to why stock markets fall.
Although larger falls, such as market corrections, are generally caused by a change in investor sentiment linked to a specific economic event or news. It’s one of the main reasons why predicting what will happen to the markets over the short term is near impossible.
New stock market highs and expensive company valuations can be an economic bellwether that a market correction might not be too far away. Periods of continued upgrowth can cause certain investments, sectors or markets to become overvalued. This can cause investors to cash in on profits and reinvest in areas that might be underappreciated and undervalued.
The bottom line is, a market correction occurs when there are more investors selling shares than there are buying shares, lowering market demand.
Here are some key factors that can trigger a change in markets:
Inflation – rising inflation has typically been bad news for the stock market as higher costs for companies can eat into the bottom line. It’s also more difficult to earn a ‘real’ return – a return which is higher than the rate of inflation.
Interest rates – generally speaking, interest rates and stocks have tended to move in opposite directions. When rates rise, it should, in theory, make cash savings more attractive. If your savings at the bank are making a reasonable return, it becomes harder to justify the extra risks that come with investing. Plus, things like mortgages and credit card debt become more expensive, so people have less to spend. This can have knock-on effects on company profits and ultimately returns.
Geopolitical events – events such as general elections, budget announcement and wars can impact investor sentiment for a particular country or stock market. The Russia/Ukraine crisis was a recent example of this.
Natural disasters and global pandemics – the Covid-19 crisis was a prime example of shock events which can cause markets to react. Global restrictions and lockdown created a huge amount of certainty about how companies would fare and if they could continue to generate profit under such extreme conditions.
How to invest during a market correction
The key message for investors is to not panic. Sometimes doing nothing is best.
Selling your investments on the worst days in the market could mean you miss out on the best days.
Short and sharp falls in the value of your investments are uncomfortable to watch. But it’s important to resist the urge to make any reckless and irrational decisions based on emotion – it’s rarely a recipe for success.
If you’re new to investing, you might not have experienced a market correction before. The first one is probably the most nerve-wracking.
However, once you’ve seen your investments drop in value and then hopefully recover, future market corrections should be less stressful.
Investing for the long term, over at least five to ten years, and sitting tight during the market wobbles should give you the best chance at achieving investing success.
Of course, nothing is guaranteed when investing and past performance is not a guide to the future. There’s a chance the value of your investments might not recover, and you could get back less than you invest.
While it’s easier said than done, topping up your investments after a recent market correction could help lower the average price paid for your investments over time.
It’s important to weigh up the risks with this approach though. It’s difficult to know where ‘the bottom’ of a market correction is, and prices could continue to fall back further into a bear market – where prices fall by 20% or more from its recent peak.
As always, any investments you buy should be based on your investment objectives, attitude to risk and there should be a specific need for that investment in your portfolio. If you’re unsure whether an investment is right for you, seek advice.
Diversification is a key factor to softening the blow from market falls. Holding a mix of investment types, like shares, bonds and commodities can help shelter your portfolio from the worst of the market falls.