What’s the difference between a market correction and a crash?

What's the difference between a market correction and a crash?

Although it can be incredibly stressful for investors, volatility is a completely normal part of a well-functioning share market. In this article, we take a closer look at some of the terminology used to describe falls in share prices – in particular, market ‘corrections’ and market ‘crashes’.

What is a market correction?

 A market correction has quite a technical definition in finance. It refers to when the price of an individual share, industry sector, or even the share market as a whole, declines by between 10% and 20% from a previous high. It is usually relatively short term in nature, taking place over the course of two to four months.

For shareholders, any sizeable loss in value can be a nerve-racking experience. But it’s important to remember that these sorts of price pullbacks are a normal part of the cycle of healthy financial markets.

Corrections typically occur when prices have risen too high, too quickly. When this happens, investors may be more likely to take some of their profits off the table by selling their shares, which in turn causes prices to decline. 

If enough investors decide to sell their shares simultaneously, it can push prices down substantially, potentially leading to a correction.

A correction can be broad in scope, affecting the entire market, or limited to a particular industry or even just a single company. 

Evidence of mismanagement or poor financial performance can lead to investors en masse dumping their shares in a company, which may cause its share price to drop by more than 10% in a fairly short period of time and enter correction territory. This happens as the market consensus of the company’s valuation changes in light of new information, like a recent negative earnings report or media release.

Just think of it as the market ‘correcting’ a situation where shares have become too expensive by bringing their prices back down in line with their underlying or intrinsic values.

When was the last market correction?

In January 2022, the benchmark S&P/ASX 200 Index (ASX: XJO) – which tracks the value of the 200 largest companies on the ASX by market capitalisation – officially entered correction territory. Investor concerns about rising interest rates and runaway inflation – not to mention the growing spectre of violent conflict in Eastern Europe – pushed the value of the index down by more than 10% from its August 2021 high.

By the end of March, the index had largely recovered, making this an almost textbook definition of a correction: a reasonably short-lived drop in prices of between 10% and 20% from a previous high.

How to recognise a market correction versus a dip

A company’s share price dip is generally only a relatively small, brief drop in price below an otherwise steady long-term uptrend. Because the underlying demand for the company’s shares remains strong, the share price tends to recover and continue upward quickly.  

Many investors try to ‘time the market’ by looking out for dips in share prices and using these as opportunities to buy them on the cheap. It’s called ‘buying the dip’. However, this is incredibly difficult to do consistently because you never know ahead of time whether a price drop is just a brief dip or the beginning of a more prolonged correction – or even an all-out crash.

What is a stock market crash, and how is it different from a correction?

A stock market crash is an extremely sudden and severe drop in prices. If you thought a 10% drop in prices was terrible, in these seismic market events, the share prices of some companies could even plunge close to zero!

Crashes are very quick as well, sometimes taking place over a matter of days or weeks. Many share markets around the world suffered large, swift crashes at the beginning of the COVID-19 pandemic. For example, the S&P/ASX 200 index shed more than 30% of its value in less than a month in March 2020, as cities across the globe went into lockdown, and international borders were slammed shut.

One of the most famous stock market crashes was the Wall Street crash of 1929, which precipitated the Great Depression. The excesses of the roaring twenties led to heightened speculation on the share market, driving prices up to unsustainable levels. Eventually, the bubble burst, resulting in some of the most significant single-day market declines in Wall Street history.

Crashes are different to corrections because of their severity and swiftness. While corrections describe losses in value of between 10% and 20% over the course of a few months, crashes can result in much larger declines above 20% and often play out over just a few days.

What is a bear market?

A bear market describes a lengthy period in which there is a general slowdown in the economy and the share market suffers a sustained loss in value. Investor sentiment tends to be overly pessimistic during bear markets.

Despite its severity, the Wall Street crash of 1929 actually only marked the very beginning of a much longer bear market. By July 1932, the Dow Jones Industrial Average (INDEXDJX: .DJI) had shed almost 90% of its value – and it didn’t return to its 1929 highs for more than two decades, until November 1954!

A bear market differs from a correction because prices drop by more than 20%. However, it is also different from a crash because it takes place over a much longer period of time. A crash or correction can easily turn into a bear market if they become severe and long-lasting enough.

The opposite of a bear market is a bull market, which describes a period in which economic conditions are favourable and share prices generally trend higher. Investors generally tend to feel optimistic during bull markets.

The names come from the fact that a bull thrusts its horns upwards, while a bear swipes its claws downwards. These are used as visual metaphors to describe the direction of market trends.

Can you protect your portfolio from a market correction?

It is next to impossible to protect yourself from the effects of a market correction fully. Unfortunately, volatility is simply a natural part of the share market. But there are steps you can take to reduce the severity of its impact on your portfolio.

One of the most important things you can do is diversify your investments across multiple companies and industry sectors. That way, if certain companies or industries suffer corrections, some of your losses may be offset by gains made elsewhere.

Another thing you can do is follow a dollar-cost averaging (DCA) investment strategy.

This involves breaking up the amount you want to invest into smaller pieces and investing them periodically – say once a week – over time. Dollar-cost averaging takes a lot of the guesswork out of investing, as it relies on making regular, consistent investments rather than trying to time the market.

This is a particularly effective strategy to adopt when markets are volatile, as it means you end up averaging out your purchase price amid the highs and lows. The longer you keep a strategy like this up, the less effect short-term movements in share prices – like crashes or corrections – will have on the value of your portfolio. Just be mindful that the transaction fees on all those individual trades will impact your returns somewhat.

Key takeaways

Although market corrections and crashes can be scary for shareholders, they are just a normal part of financial markets. The best thing you can do in a crash is not panic. Try to see it as an opportunity to pick up extra shares at bargain prices.

And although you can’t protect your portfolio fully against the effects of market volatility, there are several steps you can take to reduce its severity. Hold a diversified portfolio of investments across multiple companies and industries, and consider a dollar-cost averaging approach, as this can help smooth your returns over time.

 

Last updated 13 April 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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