You might have heard that the stock market is like a roller-coaster ride, but does it always go smoothly in your favour? What do you do when stocks fall into a correction – a steep, stomach-twisting decline of at least 10% from a peak?

The current stock market correction, which began Feb. 19, is particularly turbulent. U.S. markets have quickly gone from setting a series of record highs to a volatile churn in which stocks are conceding huge chunks almost every other day.

On March 9, for instance, the S&P 500 dropped 7% at the open as the coronavirus outbreak spread, oil markets looked primed for a price war and bond yields continued to fall to record lows.

That fall was deep enough to trigger market circuit breakers that stop trading for 15 minutes, and the index closed more than 7% lower.

It’s easy for investors to get scared when facing any sort of market downturn. That said, market corrections happen more than you might think. Let’s take a deeper look into what a stock market correction is and all you should know about it.

• What is a Stock Market Correction?
• Why Does a Stock Market Correction Happen?
• How do you Prepare for a Stock Market Correction?
• What you Shouldn’t do When Preparing for a Stock Market Correction
• 8 Thing you Need to Know About Stock Market Correction

What is a Stock Market Correction?

investors have many words for a decline in the stock market. But a stock market correction is a fairly specific type of drop: It is a fall of at least 10% (but less than 20%) from a recent market high.

Read Also: How do Investors Make Money in a Falling Market?

That distinguishes it from the following:

• 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.

Investors use these terms to describe the market as a whole, but individual stocks experience the same phenomena, and usually with much more volatility.

Whereas it’s a big deal if the market declines 10%, it’s not unusual to see a stock plummet 20% or more during that period.

Why Does a Stock Market Correction 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.
• 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 do you Prepare for a Stock Market Correction?

It is impossible to know where the stock market is headed next. And if anyone tells you where the market is headed, they are probably trying to sell you something.

While you might hate the idea that you have no idea what stocks will do next, the solution is simple: strive to create an investment strategy that will perform regardless of when (not if) the next stock market crash occurs.

Investing for the next stock market crash isn’t rocket science, but there are several proven principles for investing success to consider. Those principles include:

1. Buy, Hold, And Stay The Course

Staying the course is a surefire way to get the investment return of the stock market.

Why?

Because it’s academically proven that’s how you make money: by being invested in the market, and not by jumping in and out of your investments.

Jumping in and out of the market only guarantees that you’ll pay more in trading fees. And fees are something you must avoid at all costs, (pun intended). That’s because fees eat away at the amount of money you make investing. Staying the course works!

Historically, staying the course has generated handsome investment returns – even through some of the worst market crashes imaginable.

How much would you have earned if you stayed the course from 1980 to 2016?

Approximately 11 percent per year on average over a span of 37 years.

This is the type of reward people have seen historically when they invest for the long run.

2. Diversify

Another great way to design your portfolio to weather market crashes is diversification. By not putting all your eggs in one basket, you are reducing risk – thus giving you the potential to score on investments that zig while others zag

How would you like an investment that can increase in value when the U.S. stock market declines?

Then look no further than United States government bonds – arguably the most valuable asset of a diversified portfolio.

This is just one example of how diversifying can help you weather the ups and downs of the stock market, but there are plenty more where that came from.

3. Pick The Right Stock/Bond Mix For You

Another great way to design your portfolio for the next stock market crash is to create a portfolio that you can stick with!

If you can’t stomach the ups and downs of the market, either:

• Don’t look at your investments!
• Opt for fewer stocks, picking up more U.S. government bonds for your portfolio instead.

While bonds have historically underperformed stocks, being able to stick with your investments through the ups and downs is more important than trying to maximize returns.

Why?

Because if you invest in 100% stocks and then sell everything at the next market bottom, you’re going to lose money. If you choose a lower-risk portfolio you can stick with, that’s always a winning strategy.

4. Choose The Right Type Of Bonds

There are many, many types of bonds. For example, you can choose among:

• high-quality corporate bonds
• junk bonds
• municipal bonds
• international bonds, and even
• emerging market debt

And of course, there is also the infamous mortgage-backed security. With so many bonds to choose from, which bonds should you hold to best prepare your portfolio for the next market crash?

The truth is, you may not want to hold any of the above.

Some make the case that the only bonds you should hold are United States Treasuries bonds.

Why?

Because United States Treasuries may be the most valuable diversifier when it comes to your portfolio.

The above-linked research has shown that, in a market correction, nearly every single liquid investment moves in the same direction: downward.

One exception is United States Government Bonds (a.k.a. Treasuries). Treasuries frequently show little decline – and sometimes increase in value when the stock market heads down.

For this reason, holding Treasuries may be the single best way to prepare your portfolio for a market correction.

5. Consider International Stocks And REITs

Many investments tend to decrease in value simultaneously during a market crash. However, these investments may not do all do so to the same degree – or at the same time.

This is why it makes sense to hold not only United States stocks, but also stocks from all across the world. Like U.S. stocks, global stocks can be broken down into developed and emerging economies.

Adding a slice of real estate via Real Estate Investments Trusts (REITs) to your portfolio may make sense, too.

Unfortunately, we do not know ahead of time which investments will decrease more and which will decrease less during the next market.

But, what we can do is hold a little bit of each of every type. That way, when one type of investment decreases more than another, we are in the best position to rebalance our portfolios.

6. Have An Investment Policy Statement (IPS)

Following a stock market crash, your investments are likely worth much less than they were just days ago.

Fortunately, your United States Treasuries may be worth just a little bit more. This is because market participants panic during a crash – shunning the downward-dropping stocks for the safety and comfort of United States Treasuries.

Because of all this, your portfolio is now out of balance.

How do you know that your portfolio is out of balance? Because your Investment Policy Statement (IPS) says so.

An IPS is a document that states how you (or your financial advisor) are going to invest your money. Your IPS can be very detailed (such as elaborating on the tolerances for an increasing equity glidepath) or very simple.

At the very least, your IPS will dictate what percentage of your investments will go to globally-diversified stocks, and what percentage of your money will go to United States Treasuries.

With your IPS already in place and a market crash behind us, you’ll need to rebalance your portfolio.

What this means is, you need to sell the investments that have increased in value. (This will most likely be your United States Treasury bonds.)

From there, you need to buy investments that have decreased in value. (This will probably be your stocks.)

You need to be prepared to do this – and not just mentally, but emotionally. You need to know that, eventually, you are going to put more money into what has just decreased in value – and sell the one thing that has made money during a panic!

This must be hard. However, this is an amazing investment opportunity. Buying low and selling high is too good an offer to pass up. You have to take advantage of stocks when they are on sale. That’s how you make money investing.

What you Shouldn’t do When Preparing for a Stock Market Correction

Here’s what you probably shouldn’t be doing to your portfolio today, along with common mistakes investors make when preparing their portfolio for a market crash.

Shorting The Stock Market Is Very Risky

Shorting the market is not a foolproof strategy. You never know when the market is going to correct. As such, you could be shorting the market for a very long time.

Shorting the stock market can be a very expensive proposition that likely will not payout.

Why not?

Because more often than not, stocks go up in value rather than down. If you’re shorting the market, the odds aren’t in your favor.

Inverse Funds Don’t Sense As A Long-Term Play

We’ve already covered why it simply does not make sense to short the market in the point above.

So, if shorting the market doesn’t make sense, why opt for a tool that is poorly designed for shorting the market?

Most (all?) inverse funds are designed to be held for less than a day. These are tools for day-trading. Holding an inverse fund for long periods of time (longer than eight hours) as protection against a market correction doesn’t make any sense.

Alternative Investments As A Stock Market Hedge Don’t Work

Just because an investment charges a high fee does not mean you’re safe from stock market corrections.

In fact, portfolios holding alternative investments have been shown to do worse during a stock market recovery. This is because alternative investments charge very high fees.

The fees on alternative investments are so high that managers of these alternatives investments simply cannot make up for in investment returns for the amount they charge. The numbers just aren’t there.

Not only are alternative investments very often poor performers, but their lack of liquidity means giving up the greatest opportunity that happens during a stock market crash: rebalancing.

If you can’t sell something to buy something else, you’re missing out on a basic tenet of investing we’ve already covered: buying low and selling high.

Insurance Products To Protect Against A Stock Market Crash Is A Sales Pitch

Despite what an insurance salesperson might have you believe, investing in an indexed annuity, whole life insurance policy, or universal life insurance policy is not the best way to protect yourself from a market crash.

Numbers show that, after accounting for the fees on these products, you’re way better off sticking with a portfolio of low-cost stocks and bonds.

If you need insurance anyway, you can always buy term life insurance and invest the difference.

Hoarding Gold Is Not A Smart Investment

In the short term – as in, the day of the stock market crash – gold may do well. But, as a long-term investment, the numbers show that is not the case.

On a long timeline, you’re best served by holding a portfolio of diversified stocks and United States Treasuries.

Do Not Buy Non-Traded REITs

Non-Traded REITs have some challenges as alternatives investments. Both alternatives and non-traded REITs have high fees. This means they may likely offer poor investment returns.

Also, both are illiquid, meaning you can’t sell a portion of them to help rebalance your portfolio after a market crash.

If you believe in diversification and want to add real estate to your portfolio, consider low-cost publicly traded REIT funds.

8 Thing you Need to Know About Stock Market Correction

Here, we look at eight things you should know about stock market corrections to better help you deal with the current one.

1. There Are Multiple Types of Declines

When you’re watching red numbers flash on your computer screen, it might not matter what the financial whizzes are calling a selloff.

But there are actually multiple types of market downturns that investors have decided to give name to, based on how far stocks have fallen from their recent highs.

• A pullback is the least severe selloff. There’s no official definition, but many investors and traders will use “pullback” to describe a market decline of between 5% and just under 10% from a peak.
• Then comes a correction, which is a loss of 10% to just under 20% from a peak.
• Finally, and most severe, is a bear market, which represents a decline of 20% or more from a peak.

Whether this correction turns into a full-blown bear market remains to be seen. Historically speaking, bear markets are relatively infrequent – the most recent was in 2009 and preceded a prolonged ruin that became the longest bull market on record. Since 1926, there have been only eight bear markets.

The worst, which came during the Great Depression, saw stocks drop by more than 83%, says David Reyes, a financial advisor and chief financial architect at Reyes Financial Architecture in San Diego.

2. Pullbacks and Corrections Are Common

During the 2009-20 bull market, the S&P 500 has seen 13 pullbacks and eight full-fledged corrections, says Michael Sheldon, executive director and CIO of RDM Financial Group at Hightower, located in Connecticut.

Before the COVID-19 coronavirus-induced correction in February, the most recent correction came during the fourth quarter of 2018, when the market nearly fell into bear territory as interest rates rose and trade war tensions escalated.

Other triggers of corrections in the past decade include an economic slowdown in China in 2011, the downgrading of the U.S. credit rating in 2011, rising oil prices, the devalued yuan, Brexit and fears that Greece would leave the European Union.

“Pullbacks and corrections are a normal part of investing,” Shelton says.

3. Stock Market Corrections Can Happen Really Fast

If you’ve ever dieted, you know it’s a lot easier to put on the weight than it is to take it back off again.

The stock market kind of works in the same way: Economic growth and expansion take a long time, but if you slip into a correction (or even a bear market), buckle up.

“Corrections are vicious and they are fast,” says Anthony Denier, CEO of Webull Financial, a commission-free trading platform with more than 11 million users.

“They catch everyone off guard – just a couple of days before the markets dropped 1,000 points, everyone is on CNBC cheering all-time highs.”

Part of that is a result of stop-loss orders that automatically trigger trades if a stock falls below a certain level.

And part of it is a little bit of greed: When the market is at historic highs, it’s only natural for some investors to take any sign of weakness as a sign to take their profits, Denier says.

“All of a sudden, it becomes its own beast and starts feeding itself.”

“You can see new highs every day in a bull market, but it’s like the old cha-cha: one step forward, two steps back,” Denier says. “A selloff is always much more vicious and much faster than a rally.”

4. Corrections Often Are Driven by Fear and Speculation

When you look at stock market corrections over the last decade, not many are purely organic in nature. Corrections don’t often happen because an indicator such as interest rates or currency valuation gets out of whack.

It’s much more common for a correction to happen because investors are trying to predict future events and hedge their bets against what might happen, rather than looking at what is currently going on.

“A lot of it is fear of the unknown,” says Dwain Phelps, founder and CEO of Phelps Financial Group in Kennesaw, Georgia. “I always talk about two emotions in investing: fear and greed.

Depending on the situation, one of those emotions will always be prevalent. (In February), fear was prevalent, and we had pullbacks and it led to a correction.

Indeed, much of the current pullback has come amid a nominally low case count of coronavirus in the U.S.

That’s because investors are acting out of anticipation of what they’ve already seen in other countries, which is case counts and deaths increasing, and economic activity being disrupted.

5. A Selloff Can Be “Healthy”

Much as broccoli, Brussels sprouts and carrots are good for your diet, sometimes a dose of market reality in the form of a correction can end up being beneficial in the long term.

After all, nobody can survive forever living on a sugar high. The same goes for a stock market that is artificially propped up through accounting tricks, Phelps says.

“In my opinion, I think corrections are needed at times in the market. I do feel there are in particular times stocks that are overvalued, so having a healthy correction that brings value to the market would be beneficial to investors.”

As an example of a “healthy” correction, Phelps points to the presidency of George W. Bush and the quantitative easing policies that drove the market.

“We were printing money and we were dropping interest rates, and what we did from the economic standpoint was that instead of allowing things to organically materialize, we were kind of producing it ourselves,” he says.

“Stock prices would go up because things appear that they are operating organically, but they are not. It’s kind of being manufactured.”

6. Corrections Are an Opportunity to Buy Stocks at a Discount

Investors with a long time horizon can and should view corrections (and even bear markets) as an opportunity.

These drawdowns in price are a perfect time to look at stocks with fundamental strengths that are suddenly available at a discounted price.

For instance, Apple (AAPL) shares dropped by nearly 19% between Feb. 11 and March 9, from about $327 to $266 per share.

Investors who maintained some cash reserves and still believed in Apple’s long-term prospects had a golden opportunity to grab their stock at significantly lower prices than before.

“The longtime investors are understanding that it goes with the territory,” Phelps says. “They are looking to take advantage of things that are on sale.

Your inexperienced investor who has only been in the market for a couple of years, they are the ones that you have to kind of talk to and walk them through what’s going on.”

Just remember that investing is far more than price. You don’t just want something cheap – you want value.

7. Market Corrections Are Challenging for Retirees, However

What happens when you don’t have a long time horizon?

If you are retired or nearing retirement, it can be downright scary to see your 401(k) balance take a significant hit when your earning years are behind you.

“The most challenging time for baby boomers is as they get close to retirement or if they’re just starting retirement, and the uncertainty that comes with the drawing down of their accumulated wealth that they’ve accumulated over time,” Sheldon says.

Making things a little more difficult is that bond yields are at historic lows, and life expectancies continue to grow.

So while bonds have certainly helped offer protection throughout the downturn so far, some retirees might need to keep a significant portion of their portfolio in equities – perhaps going even more aggressive than the classic 60/40 (60% stocks, 40% bonds) allocation that portfolio managers have traditionally suggested.

“Volatility at that time can be more challenging and make someone question if they should continue to have the asset allocation they have,” Sheldon says.

8. A Financial Plan Helps in a Stock Market Correction

As with many things, having a plan for dealing with market declines is the best way to navigate troubled times rather than making spur-of-the-moment decisions that are off the cuff.

You can put your portfolio through a series of stress tests, calculating how it would respond to various market scenarios, and make sure that your risk tolerance is in line with your objectives.

“One of the things we always do when a client comes in is we create a financial plan,” Sheldon says. “Based on that plan, we can figure out the correct asset allocation and the appropriate risk/reward that the client should have to meet their long-term investment goals.

Read Also: Make Money Online Through Stocks Trading

“One of the important things about the financial plan is that it sets an allocation so the client can ride out the ups and downs that come with investing,” he says.

“The most difficult thing for investors is to experience or pullback or correction the market that can lead to an impulsive reaction to sell stocks or raise cash at inappropriate times, which can affect long-term performance.”

Conclusion

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.

Now that you know what a stock market correction is, it’s time to get yourself prepared with the tips and suggestions provided above.