Financial markets exhibit inherent volatility, characterized by growth periods and occasional downturns, with market corrections being a common occurrence.
Today, I aim to clarify market corrections, differentiate them from other market events, and offer some strategies on what to do during these periods.
What is a Market Correction?
A market correction is generally defined as a decline of 10% to 20% in a major stock market index, such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite, from its most recent peak. A recent example of this occurred on March 13th of the current year, when the S&P 500 entered correction territory after falling roughly 10% from its high point in mid-February.
Market corrections can be potentially beneficial for the overall health of the market 16. They can act as a way to moderate excessive optimism or “euphoria” that might have driven asset prices to unsustainable levels, preventing the formation of larger and more damaging asset bubbles. The term “correction” itself suggests a return of prices to a more sustainable, long-term trend after a period of rapid appreciation.
Market Correction vs. Bear Market vs. Market Crash
It is essential to differentiate a market correction from other, more severe market downturns: a bear market and a market crash. A bear market is characterized by a more substantial and prolonged decline of 20% or more from a recent market peak. Bear markets often reflect a more significant erosion of investor confidence and are frequently associated with a weakening or slowing economy.
In contrast, a market crash involves a rapid and often dramatic drop in stock prices, typically a double-digit percentage decline occurring within just a few days. The key differentiator of a crash is the speed and intensity of the price decline compared to the more gradual nature of a correction.
The following table summarizes the key differences between these types of market downturns:
It is important to note that these market events are not always mutually exclusive. A market correction can, under certain circumstances, deepen and evolve into a bear market if the downward pressure persists.
From a financial planning perspective, a market correction can be an opportune time to consider several tactical actions:
1. Maintain a Long-Term Perspective and Avoid Panic Selling: We generally advise against reacting impulsively and selling investments during a downturn, as this can lock in losses and cause you to miss the eventual market recovery. Some of the best days in the market come very quickly or even during a market downturn, and often, investors will miss out on participating in those if they panic sell in a correction.
2. Continue Investing Regularly (Dollar-Cost Averaging): If you have a regular investment plan, such as through a 401(k) or IRA, continuing to invest a fixed amount at regular intervals can be beneficial. This strategy, known as dollar-cost averaging, allows you to buy more shares at lower prices during the correction, potentially leading to better long-term returns when the market recovers.
3. Roth IRA Conversion: As discussed previously, a market correction can lower the value of assets in your traditional IRA, potentially reducing the tax liability associated with converting those funds to a Roth IRA. This allows for future tax-free growth and withdrawals.
4. Tax-Loss Harvesting: If you have investments in taxable accounts that have declined in value during the market correction, you could sell them to realize a capital loss. These losses can be used to offset capital gains taxes or even a limited amount of ordinary income. Keep in mind the “wash-sale” rule, which prevents you from immediately repurchasing the same or a substantially similar investment within 30 days.
5. Increase Contributions to Health Savings Account (HSA): If you are eligible for an HSA, a market correction might be a good time to consider increasing your contributions if your cash flow allows. The money in an HSA grows tax-free, can be withdrawn tax-free for qualified medical expenses, and can even act as a retirement savings vehicle. Investing within an HSA during a market downturn allows you to buy at potentially lower prices, setting up the potential for greater tax-free growth in the future.
6. Review and Potentially Adjust Asset Allocation: While staying the course is generally recommended, a significant market correction might prompt a review of your portfolio’s asset allocation. If your risk tolerance has changed or your portfolio has become significantly unbalanced, you might consider making modest adjustments to bring it back in line with your long-term goals.
7. Rebalance Your Portfolio: As mentioned earlier, a market correction can cause your portfolio’s asset allocation to drift from your target. Rebalancing involves selling assets that have become overweight and buying those that are underweight to bring your portfolio back to its intended balance. This can help manage risk and ensure your portfolio remains aligned with your long-term objectives.
It’s important to remember that the best course of action will depend on your individual financial situation, risk tolerance, time horizon, and long-term goals. Consulting with a qualified financial advisor can help you determine the most appropriate strategies for your specific circumstances.
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