What is a stock market correction and what does it mean for you?
When the stock market goes down 10%, there is no need to panic. You can consider it a “necessary evil”, or as those on wall street like to call it – a stock market correction.
Contrary to how it sounds, a stock market correction is when stock prices drop rather than being ‘corrected’ to go up. A stock market correction occurs when an event (or series of events) causes the overall value of stock prices to drop by 10% or more. A bear market is when the stock prices drop by 20% or more.
According to Fidelity, on average the top 500 stocks (also known as the S&P 500) have experienced a 5% drop 3 times a year, a 10% correction once every 16 months, and a 20% decline (bear market) every 7 years.
Even though the market may fall, the overall trend has been up. That’s a good thing for your money. Let’s look at why stock prices go up and down and what this means for your investment strategy.
How are prices on the stock market set and why do they fluctuate?
The stock market is where investors like yourself can buy and sell investments- most commonly stocks. Stocks are a small slice of ownership in a company. What you pay for it depends entirely on supply and demand.
How are prices for stocks set?
Each company typically has a fixed supply of shares, sold as stocks. As demand increases, meaning more people want to buy the stock, then the price of each stock goes up, and vice versa.
Why do stock prices change so frequently?
The interest in stocks, or the supply and demand, is heavily influenced by how investors ‘feel’. This ‘feeling’ that drives investing decisions can be impacted by:
- Expectations of a profit
- Sentiment towards certain industries, sectors, countries, or specific companies
- Macroeconomic changes, such as employment, growth, consumption, industrial production, government changes etc.
These three factors all drive how investors ‘feel’ and therefore make decisions about certain stocks. Individual opinions sum to the wisdom of the crowd, and as opinions are constantly changing, this causes fluctuations in the market.
Stock Market Corrections Vital Role
When significant events happen in the world, investors react accordingly. For example, the COVID-19 global pandemic caused a shift in investor sentiment on industry performance and company profits. This caused a drop in the price of stocks and consequently a massive drop in the market.
Put simply, ‘corrections’ are events that adjust market prices to be in line with (changed) expectations. This kind of volatility is normal and it’s important that you don’t let it dictate when you start or stop investing.
Short term vs. Long term Mindset
The stock market can build your wealth over the long term. You can’t time the market and you shouldn’t wait on the sidelines for the ‘right time’ to participate. History has shown, the market will correct and then normalize, so you are better off realizing returns from your investments by sticking it out through a correction.
Peter Lynch, one of the most well-known investors to this day sums this up perfectly stating, “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.” Investing in long term valuable companies is a strategy that helps you weather short term fluctuations like a correction.
How much has the market gone up, and will it continue?
Over the past 90 years, the average total return for the largest 500 companies in the US has been 9.8% per year. During this time, markets experienced ‘corrections’ due to the changing of circumstances.
Our belief is that over the long run, market performance will continue to trend upwards. Why?
The market represents the value of the companies in an economy and there is a strong prospect of new technologies, new companies, and economic growth. These factors, plus inflation, should mean that over the long run, market performance will continue to increase.
Ray Dalio, one of the best investment managers in the world echoes this belief and states, “The world, over time, will improve, will grow and will be a better and more efficient place to live than it was before.”
These factors drive our belief that investing in the stock market will continue to be one of the greatest creators of wealth.
How should you react to a stock market correction?
In the short term, markets can be volatile. It is important to think about the longer term, and whether your investment portfolio matches your risk profile and caters to your financial goals.
This is especially true for younger investors that have a long time horizon for their investments to grow. Most have decades before retirement, so even if a recession hits now, there’s plenty of time for investments to bounce back with the stock market.
The best strategy is to re-evaluate your financial goals and stay consistent. Routinely contributing to your investments takes the emotion out of investing and stops you from trying to time when to buy low and sell high.
We at Finch don’t believe in timing the market, rather we believe in time in the market. That’s why we created an investing platform that lets you get started investing right away with the money you would normally keep idle in your checking account.