What Is a Correction?

A correction is generally defined as a decline of 10% or greater in the price of a security from its most recent peak. Corrections can occur in individual stocks, indexes, commodities, currencies, or any asset that is traded on an exchange. An asset, index, or market may fall into a correction either briefly or for sustained periods of time, including days, weeks, months, or even longer.

The average market correction is short-lived and lasts anywhere between three and four months. While this may not seem like a long time in the grand scheme of things, it is easy to see why individual investors may be worried by a 10% or greater downward adjustment to their assets during this period, especially if they are new to investing or it is the first correction they have experienced. And of course, a dramatic correction that occurs in the course of one trading session can be disastrous for a day trader.

How a Correction Works

Prior to a market correction, individual stocks may still be strong, or even over-performing. Conversely, during a correction period, individual assets frequently perform poorly due to adverse market conditions. Corrections are often seen as ideal times to buy high-value assets at discounted prices for investors with available capital who are willing to take the risks involved.

Corrections can sometimes be projected using market analysis, and by comparing one market index to another. Using this method, an analyst may discover that an underperforming index may be followed closely by a similar index that is also underperforming. A steady trend of these similarly slowing indexes may be a sign that a market correction is imminent.

Although market corrections can be challenging, and a 10% drop may significantly hurt many investment portfolios, corrections are sometimes considered healthy for both the market and for investors. For the market, corrections can help to readjust and recalibrate asset valuations that may have become unsustainably high. For investors, corrections can provide both the opportunity to take advantage of discounted asset prices as well as to learn valuable lessons on how rapidly market environments can change.

Key Takeaways

  • A correction is a decline of 10% or greater in the price of a security, asset, or a financial market.
  • Corrections can last anywhere from days to months, or even longer.
  • While damaging in the short term, a correction can be healthy, adjusting overvalued asset prices and providing buying opportunities.

Real World Examples of a Correction

Market corrections occur relatively often.

Between 1980 and 2018, the U.S. markets experienced 37 corrections. During this time, the S&P 500 had fallen by an average of 15.6%. Ten of these corrections resulted in bear markets, which are generally indicators of economic downturns. The others remained or transitioned back into bull markets, which are generally indicators of economic growth and stability.

Take the year 2018, for example. In February 2018, two major indexes, the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 index, both experienced corrections, dropping by more than 10%. Both the Nasdaq and the S&P 500 also experienced corrections in late October 2018.

Each time, the markets rebounded. Then another correction occurred on Dec. 17, 2018. Both the DJIA and the S&P 500 dropped over 10% (the S&P 500 actually fell 15% from its all-time high). Declines continued into early January. Predictions that the U.S. had finally ended a bear market abounded.

Then, the market began to rally, erasing all the year's losses by the end of January. As of mid-April 2019, the S&P 500 is up about 20% since the dark days of December. Optimistic analysts are saying the bull market still has the legs to run, though a few pessimists fear the upswing could be a short-lived bear market rally, aka (to use another animal metaphor) a dead cat bounce.