By Stephen Kyne, CFP
With market indices at, or near, all-time highs, it’s natural for some to wonder if they can go any higher? Never mind the fact that every all-time high has necessarily been prefaced by every other all-time high, loss-aversion makes many investors wary of a cliff. This is when you may start hearing the word “correction” tossed around.
So, what is a correction?
The standard definition of a market correction is a 10 percent pullback in the value of an asset, like a stock, or of an index, like the S&P 500. These pullbacks can happen slowly over a period of time, or as quickly as in a single day. Corrections can vary in length, as well, from just a few days to a several months.
Market corrections are notoriously difficult to predict, however they generally happen when the price of assets far exceed their fair value, and markets become overly inflated. How inflated an asset must become is the great unknown.
Understandably, a 10 percent drop in the price of assets sounds like something that should be devastating. In the short-term it can be, but in the long-term corrections can be a boon to the market. Since market corrects tend to be overly broad, can they provide opportunities for investors to rebalance their portfolios and reallocate from areas that are truly overvalued, to those which may be undervalued.
While eliminating the effects of a correction may be impossible, mitigating the effects can be much more feasible. A properly diversified portfolio, a basic tenet of investing, can be your best defense against the impacts of a correction. Although diversification can’t guarantee against losses, it can help soften the blow when the eventual correction happens by.
So, what can be done during a correction?
The biggest mistake investors make during a correction is to panic. People are naturally tuned to loss-aversion, which tends to make them react exactly when they shouldn’t. Selling into a down market only drives prices further down, and exacerbates the effects of the correction. Savvy investors know that, for this very reason, corrections provide a buying opportunity. Knowing, and doing, however, is the tricky part!
It’s important to remind yourself that, historically, every single time the US markets have experienced a correction, they have eventually recovered to find new highs. 100 percent of the time. Now, this isn’t a guarantee by any means, but as far as track records go, it should help you sleep better at night, and help keep you from making any rash changes to your portfolio.
The accompanying chart shows you the intra-year lows and eventual annual return of the S&P 500, going back forty years. Note that in 2020, the index was down as much as 34 percent, and if you sold at the bottom that would have been your return. If, however, you had stayed invested, you would have been rewarded with a 16 percent gain. You’ll find similar stories in many other years.
Is there a correction around the corner? Nobody can say for sure. What we do know is that corrections can provide opportunities, and that long-term investors should generally not let themselves be spooked by their eventuality. Afterall, you probably wouldn’t rush to sell your home next month, just because of a drop in value.
Work closely with your certified financial planner to determine how best to position your assets so that, when a correction does come around, your portfolio is ready. Be sure to communicate with your CFP to create an investment policy around your portfolio so that you both know if and how you’ll react. Ultimately your needs will determine the proper course of action.