Market Correction: What Does It Mean?

When a stock index falls by more than 10%, it is often said to have entered “correction” territory. That’s a fairly neutral term for what feels like a nerve-wracking drop to many investors. What does a correction mean? What’s likely to happen after a correction, and what can you do to help your portfolio weather the downturn? Here are answers to some commonly asked questions:

What is a correction?

There’s no universally accepted definition of a correction, but most people consider a correction to have occurred when a major stock index, such as the S&P 500^® index or Dow Jones Industrial Average, declines by more than 10% (but less than 20%) from its most recent peak. It’s called a correction because the drop often “corrects” an overshoot and returns prices to their longer-term trend.

Is it the start of a bear market?

Nobody can predict with any degree of certainty whether a correction will reverse or turn into a bear market. However, historically most corrections haven’t become bear markets (that is, periods when the market falls by 20% or more). There have been 22 market corrections since November 1974, and only four of them became bear markets (which began in 1980, 1987, 2000 and 2007).

Since 1974, only four market corrections have become bear markets

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Each period listed represents the beginning month/year of either a market correction or a bear market. The general definition of a market correction is a market decline that is more than 10%, but less than 20%. A bear market is usually defined as a decline of 20% or greater. The market is represented by the S&P 500 index. Past performance is no guarantee of future results.

But what if it really is the start of a bear market?

No bull market runs forever. While they can be scary, bear markets are a part of long-term investing and can be expected to occur periodically throughout every investor’s lifetime.

However, it’s important to keep them in perspective. Since 1966, the average bear market has lasted just under 17 months, far shorter than the average bull market. And they often end as abruptly as they began, with a quick rebound that is very difficult to predict. That’s why long-term investors are usually better off staying the course and not pulling money out of the market.

Past bear markets have tended to be shorter than bull markets

Source: Schwab Center for Financial Research with data provided by Bloomberg. A bear market is usually defined as a decline of 20% or greater. Duration is measured as the number of days from the previous peak close to the lowest close reached after it has fallen at least 20%, and uses a 30/360 date conversion (30 days a month/360 days a year). The market is represented by the S&P 500 index. Past performance is no guarantee of future results.

What should I do now?

Worrying excessively about a bear market is counterproductive, but being prepared for one is always a good idea. It never hurts to develop an emergency kit for your portfolio. Here are some steps all investors should consider:

• If you don’t have a financial plan, consider making one. A written financial plan can help you craft an appropriately balanced portfolio. It can also calm your nerves and make it easier to stay the course when markets get bumpy: According to a recent Schwab survey, 60% of people with a written financial plan said they felt prepared for a recession similar to the Great Recession of 2007-2009, compared with 30% of people without a plan.²
• Review your risk tolerance. It’s relatively easy to take risks when the market is rising, but market downturns sometimes can be a wake-up call to consider adjusting your target asset allocation. Consider how much loss you have the emotional and financial capacity to weather. Schwab’s investor profile questionnaire can help you determine your investor profile and match it to an appropriate allocation.
• Match your portfolio to your goals and investing timeframe. Market corrections can be especially upsetting if you don’t have time to recover or you’re not sure you’ll have enough cash to handle near-term goals. However, you can structure your portfolio to take some of the worry out of watching the markets. Money you expect to need within the next two years, or that you can’t afford to lose, should be in relatively stable short-term investments like bank savings accounts, certificates of deposit or Treasury bills. Money for long-term goals can be invested in potentially higher-growth, higher-risk assets like stocks, because you will have more time to recover from a downturn.
• Make sure you have a diversified portfolio. The old adage “don’t put all your eggs in one basket” is especially important advice for investors. A globally diversified portfolio—one that puts its eggs in many baskets—tends to be better positioned to weather market swings and provide a more stable set of returns over time. Because a diversified portfolio is invested in many asset classes, it can benefit from owning top performers without bearing the full effect of owning the worst performers.
• Rebalance regularly. Market changes can skew your allocation from its original target. Over time, assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this at regular intervals.

Take your life stage into consideration

Your life stage also can affect your reaction to significant market downturns. For example:

• Younger/mid-career investor (typically 18-51 years old): If you’re a younger or mid-career investor saving for a goal that is still 15 or more years away, such as retirement, you should take advantage of your relatively long investment horizon. In short, you have time to recover, and you would generally do better to focus on your long-term goals rather than panicking about short-term market movements.
• Near retirement (typically 52-66 years old): The picture can change a bit for investors who are nearing retirement. If you’re in this age group, you probably have a more-established career than when you were younger, spend less, and focus on saving. Regular rebalancing and appropriate diversification are important for you at this stage, and your risk profile typically will become more conservative as retirement approaches.
• In retirement (typically age 67+): Retirees who are living off their savings, investments, pensions and Social Security benefits have unique needs. Portfolios for investors in retirement should be designed to support short- and intermediate-term spending needs, and to be sustainable throughout a retirement that could last 30 years or more. The typical retiree has a more conservative risk profile than younger investors, and should have a relatively larger allocation to defensive asset classes, such as bonds and cash investments. (Again, Schwab’s investor profile questionnaire can help you determine your profile and match it to an appropriate allocation.)

Also, if you’ve recently retired and begun to withdraw from your portfolio, you should be aware that poor returns in the early years of retirement can have a profoundly negative effect on a portfolio, and consider taking steps to avoid being forced to sell assets in a down market.

¹ Schwab Center for Financial Research with data provided by Morningstar, Inc. U.S. stock market is represented by the S&P 500® Index. Daily data from 01/01/2000 to 02/09/2018 were used in this analysis. The general definition for a market correction is a market decline that is more than 10%, but less than 20%. A bear market is usually defined as a decline of 20% or greater.

² Schwab 2018 Modern Wealth Index, developed in partnership with Koski Research and the Schwab Center for Financial Research. The online survey was conducted by Koski Research from Jan. 12-19, 2018, among 1,000 Americans ages 21 to 75. Quotas were set so that the sample is as demographically representative as possible. The margin of error for the total survey sample is three percentage points.