By the end of this article, you may even begin to see market corrections as an opportunity to buy the shares you love at bargain prices.
Although we're talking specifically about stock markets in this article, corrections can also occur in other markets, like bonds, property, or currencies. Individual assets, like the shares of a specific company, can also suffer corrections if their stock price falls more than 10% from their peak.
How does a market correction differ from a bear market?
In a market correction, a price fall is usually relatively shallow and short-lived. After a brief period, the market recovers and then goes on to post new and ever more impressive highs.
However, if the market doesn't recover and prices continue to fall over a more extended period (think months or even years), then a market correction can metastasise into a full-blown bear market.
A bear market occurs when prices fall by more than 20% from their highs and trend down over a sustained period of time.
For example, during the 2007-2009 bear market sparked by the global financial crisis, the S&P/ASX 200 Index (ASX: XJO) shed more than 50% of its value over 18 months.
It's also important to note that a correction, crash, or bear market doesn't affect all shares equally.
Higher-risk, speculative investments like junior companies or growth shares may see their stock prices fall by well above 10% or 20% in a correction or bear market. This is because many investors will sell their high-risk stocks and buy less risky, stable companies (like blue-chip shares) in a crisis.
And what about a stock market crash?
A crash packs the same punch as a bear market — but gets it done much quicker.
In a crash, stock prices also usually dive by more than 20% (so it is more severe than a correction), but it all takes place over just weeks — or sometimes even just a few days.
A crash can also trigger a longer-term bear market, or the market may recover quickly. For example, there was a speedy price rebound after the COVID-19 crash in March 2020. So fast, in fact, that by June 2020, the ASX was back in bull market territory again after rising more than 20% from its lows.
What causes a market correction?
There can be many reasons why a market correction might occur.
For example, it may be caused by a macroeconomic shock — like a sudden rise in oil price or another widely-used commodity. This can have far-reaching impacts across the whole global economy and could lead to a sudden drop in share prices.
A correction may also occur if there is a general souring in the economic outlook. For example, current global recession fears are due to a confluence of factors, including rising interest rates, high inflation, supply chain issues, and the lingering effects of the COVID-19 pandemic.
These factors will likely reduce the economy's output, causing a broad sell-off in equities and a general market decline.
A destabilising event, like a war or a pandemic, may also cause a sharp sell-off in shares, as we have seen recently.
Other times, it may be difficult to discern the exact reason for the correction. It may just be that the market has become 'overheated' and prices have been pushed up too high.
If there is a general sense that shares have become overvalued, investors may decide en masse to sell their holdings and realise some profits while prices are most favourable. If enough investors do this at once, it can also lead to a correction.
How often do corrections occur?
Market corrections happen relatively frequently and should be considered normal in a healthy financial market.
Sometimes, investors may become overexuberant in response to a positive piece of news and might bid up share prices to unsustainably high levels. In these cases, a correction may be needed to bring prices back down to more realistic levels.
This is a normal part of the price discovery function of any financial market — and it's why it's referred to as a 'correction' in the first place. When share prices become too overvalued, they need to be 'corrected' — that is, they need to be brought back in line with the market's underlying intrinsic value.
There are no hard and fast rules about the frequency of market corrections, but most sources on the web will tell you that they occur about once every two years on average — and perhaps even more frequently than that.
And how long do they usually last?
One of the defining qualities of a market correction is that it is usually a relatively brief and mild pullback in prices.
Any more severe, and it would turn into a crash — as we saw in the early days of COVID. Any longer in duration, and it will likely turn into a bear market.
This means corrections tend to only last for a few weeks or months before buying activity picks up again and market prices recover.
For example, the ASX 200 suffered a brief correction in late 2018, when Donald Trump was still the United States president and was waging a trade war with China.
Indeed, it says something about the times we live in that we can now look back at that period with a sense of wistful nostalgia.
Anyway, a subsequent tech sell-off prolonged the 2018 correction, which began in September and lasted until late December. By mid-2019, prices had already recovered to previous levels, and they continued rising, more or less unabated, until the COVID crash in March 2020.
Are we currently in a market correction?
Looking back at 2022, the year was particularly volatile for financial markets. In January, the ASX 200 officially entered correction territory after falling more than 10% from the highs it had reached the previous August.
Although the index staged a mid-year rally, the ongoing impacts of the conflict in Ukraine, fears of a global recession, and rapidly rising inflation have continued to weigh on the markets.
This leads some analysts to say that January's correction might eventually turn into a more prolonged bear market.
Will there be another?
Regular corrections are part of the lifecycle of a healthy financial market. They are simply a natural outcome of that wonderful tug-of-war between supply and demand that determines the real-time price of an asset.
Sometimes, corrections will occur in response to unforeseen shocks to our economic, political, or natural environments. Other times, it is just an overheated market cooling down.
Even if we can't predict the reason for the next market correction, we can be absolutely sure that there will be one.
How to prepare for a stock market correction
The best way to prepare for a market correction is not to see it as a catastrophe. Instead, view it as an opportunity to buy shares in the companies you love at significantly discounted prices (sometimes referred to as buying the dip).
Sure, it's no fun when your share portfolio is a sea of red, but if you believe in the long-term prospects of the companies you invest in, you should have faith that their share prices will eventually recover and post new highs.
This makes a correction an ideal time to start buying. As Warren Buffett once famously quipped, "Be fearful when others are greedy, and greedy when others are fearful".
That being said, there are still some steps you can take to reduce the volatility of your portfolio and protect it against sharp losses during a market correction or market downturn. This is a particularly advisable investment strategy if your personal risk tolerance is low.
For example, you can shore up your investment portfolio by buying some defensive shares and safe-haven assets like gold and bonds. These assets tend to preserve their value in a market downturn and can offset some of the losses you may experience on the riskier shares in your portfolio.