What is a Stock Market Correction? What Should I Do?

February 9th, 2018 by 

A stock market correction is a drop of ten percent in value from an all-time high in a stock index. While stock market corrections are defined mathematically, there is a large psychological aspect to the coverage of corrections. All stock indexes can be 'in correction', but capital-C Corrections happen on the most popular indexes.

When you see the financial press writing about corrections – present company included – usually a popular, broad-based index moved into correction territory. In the United States, that means the S&P 500, The Dow Jones Industrial Average, and to a lesser extent, the NASDAQ drive our correction news.

Stock Market Corrections: 10% Losses and Volatile Emotions

This article is immediately proceeded by the S&P 500 crossing the -10% psychological barrier.

On January 26, 2018 the S&P hit an interday high of 2872.87. On February 8, 2018 it crossed the -10% return barrier (2585.58) in the waning minutes of market hours, finally closing at 2,581.00 or a 10.16% drop.

Because of round number bias, humans overweight order of magnitude changes or anywhere a leading digit changes. While in a store that means you see item prices ending with 99 cents, in the investment world that means we assign special terms for round number drops.

Picture of a stock market correction

This stock market correction set the S&P 500 back all the way to... November, 2017.

Working off that principle, a 10% drop is a correction while a 20% drop defines a bear market.

Historically, psychology does come into play if stock drops avoid this bear market territory; a market that corrects then proceeds to new highs is healthy. Usually, other than for very brief bear-dips, a bear market in a major index like the S&P 500 would set a benchmark for either new market conditions or at least a change in narrative.

Witness 2008-2009; while the Great Recession declines were much larger than a mere bear market, lots of financial reporting quotes returns from 2009 or remarks about "the current bull market". The current bull market is really just shorthand for everything since the recovery. All that is despite those corrections in the S&P 500 in 2010, 2011, and 2015 (-2016).

What Should You Do in a Stock Market Correction?

First, breathe. A common quote about stock markets is they climb a staircase and descend an elevator. This week in the stock market was especially jarring because volatility spiked at the same time. This correction came on very quickly, like the aforementioned elevator.

Second, sit on your hands. For the majority of us, periodic investing is our most common investment style – often every paycheck. You probably also have lump sum investments scattered throughout the year: real estate purchases, IRA investments, 529 contributions and the like. If you've just experienced a loss, this is no time to log in to all your accounts and sell. Your adrenaline is pumping and you need to wait - in poker, this is called being on tilt. When you experience a loss and go on tilt, you make sub-optimal or risky decisions you should have otherwise avoided.

Third, plan to plan. It's often during a down market you learn you're uncomfortable with your current asset allocation. Perhaps you held riskier assets than you could stomach, or you had too much allocated to a single stock or fund. Commit to reevaluating your current mix when markets are calmer. For me, that means taking the time to evaluate my current mix (and perhaps change it) once a quarter. Don't let the market tail wag your portfolio dog.

Emotional Stock Market Correction Plan: The Self-Addressed Letter

Often in a down market, your emotions dominate your rationality. We've evolved such that the urge to DO SOMETHING feels rational during stressful times. Don't fret - there's a great way to DO SOMETHING yet still add the proper amount of red-tape to avoid doing something rash. In short, write a letter to yourself.

Now, it doesn't have to be a formal letter. However, if you can't resist the immediacy of taking some action, find some paper and write out exactly what you'd like to do.

Then wait...

Re-read the letter in a few days (or once things are a bit more calm). If your plan still makes sense, maybe that's the action you should take when you change your allocation. If it doesn't, throw the letter away, laugh, and send a few people to this site to subscribe. Either way you assuaged the immediate panic and set in motion a rational plan: yin-yang, emotions-rationality, and all that great stuff.

Should I Buy More Stock in a Correction?

This is, obviously, a personal decision – but during a correction stocks are at least 10% cheaper than they recently were. On a long enough time line, stocks usually recover – a broad index of stocks has recovered 100% of the time in the United States thus far.

Since recovery means retaking the highs even if you bought the absolute top you'd recover. Buying now means you're ten percent better off looking at the exact same scenario. Of course, make sure your timeline aligns; the common rule of thumb is don't invest in stocks if you need the principal in the next five to seven years. Start with that – for further research, try our S&P 500 historical return calculator which shows how the S&P 500 performed over various time periods.

Now yes, there are potential nightmare scenarios. For example, Japan's Nikkei has returned essentially nothing for an entire generation. We'll do an article later, but dollar cost averaging even into a true exception like the Nikkei would not have worked out horribly. Also, for the majority of you, if your country were to collapse we'd have bigger problems than saving for homes, schooling, and retirement...

When the Stock Market Corrects, Don't Over-correct Your Finances

Warren Buffett once said, "Only when the tide goes out do you discover who's been swimming naked."

If you wish you had on a little more swimsuit right now you know your asset allocation is a bit off. Without making any immediate changes, put a plan in place, or set up some time and get a financial advisor (not an engineer writing for a site named DQYDJ) to go through your investments with you. The worst thing to do is to move from an over-allocation to a wildly inappropriate under-allocation in riskier assets; not enough risk is risky.

By most common definitions of the term I'm an 'old Millennial', which means I was invested back in 2008. The dollar amounts were smaller but my first high-volatility experience was very unsettling nonetheless (and lead to the founding of DQYDJ). To me, this latest correction feels "different" than others post-2008 and I wouldn't be surprised if this one took us into bear territory.

Harsh conditions are required to forge steel. Harsh times forge your mind, and you'll emerge a calmer, more rational, and better investor. Remember: breathe, sit on you hands, plan to plan, then decide during a time of relative calm; you'll be alright. May all your returns eventually be up and to the right.

Does this time feel a bit different and are we headed for bear? Is this just a blip we won't even talk about in 2 months?



PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK is in his mid-30s and lives in New Hampshire with his wife, kids, and dog.

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