The domestic and international stock markets have started 2022 with a level of volatility unseen for the past few years. The rather benign market conditions, over the last 10 years, have lulled investors into a false sense of security and normalcy that is anything but normal.
This is completely understandable when we look at the recent history of the S&P 500, a benchmark for US stocks. The S&P 500 has only posted one year of negative returns greater than 1% since 2009. The index’s loss of 6.24% in 2018 was paltry compared to its 38% loss in 2008 and three consecutive double-digit down years of 2000-2002. This is all to say that the beginning of 2022 is a reminder that volatility and market corrections are part of the normal market cycle, not a deviation from it.
What is a Market Correction?
The term “market correction” is generally defined as a drop in a given market index of at least 10%, but not more than 20%. A drop of more than 20% is referred to as a bear market.
To give some perspective on the recent history of market corrections, the S&P 500 experienced a market correction in 11 of the past 20 years. Further, the S&P has experienced a correction, on average, every 19 months since 1928. This helps to illustrate the fact that market corrections are common over most periods of time and should be viewed as the market resetting stock valuations back to a more fundamental level.
Most economists believe that periodic corrections are healthy for investment markets, particularly stock markets, as equities tend to have large price swings. As stock prices appreciate over periods of time, there can start to become a disconnect between the valuation for a company and the price of its common stock. While the relationship of company valuations and respective stock prices can be a moving target, market corrections help to bring this relationship back in line, and, in some cases, corrections can provide a buying opportunity as the stock price may fall too far relative to the valuation. The circumstances and variables that cause the to market slide are different each time, which makes predicting when a correction will happen and for how long nearly impossible. Furthermore, many corrections have been caused by non-financial related events such as geopolitical issues or military skirmishes.
Investing During a Market Correction
Now that we have a better understanding of corrections and their history, we need to turn our attention to how we should react during a correction. Corrections can be a scary, unnerving period of time in a market cycle, however, history shows us that corrections last, on average, four months before the market makes up the loss. This is the reason why most economists recommend riding out market downturns. Often people ask the question, “why not just sell stock positions when the market begins to fall and buy back in when the market bottoms”. This is almost always a recipe for disaster as it requires correct market timing, not one, but two major moves in a portfolio. It also requires that we are actually at the start of a correction. We know that we are in a correction once the market has already fallen 10% and, by that point, it is too late to avoid the loss by selling shares. The best advice for weathering volatility in the markets is to fully understand your personal risk tolerance and accurately match your investment allocation to that risk profile. This way, we can have confidence that our portfolio is built to withstand the appropriate amount of market loss for your specific situation.