What is a ‘market correction’?

The start of 2018 has been an eventful time in the world of the stock market. After hitting highs at the end of January, both the Dow Jones and Standard & Poor’s 500 saw a considerable drop at the start of February, a fall from which the markets have now mostly recovered. At the time, however, this was reported as a ‘market correction’ by most media outlets. But what exactly does a correction mean in this context?

Put simply, a market correction is when the price of any security or market index declines by at least 10% after a recent high. There are a number of reasons why a correction might happen, but it’s regularly due to short-term gains being experienced despite very little changing in the market. The value increases are often down to the expectation of perceived gains within the mass psychology of investors. As the number of investors buying into the trend goes up, the price goes up too. Buying slows once the price reaches a certain height, and some of the investors lock their gains by selling. This in turn causes the price to go down again after the brief increase, which creates the market correction.

A market correction isn’t the same as a crash, which is a drop of 10% or more without the preceding high. Neither is it the same as the more sustained market downturn of a bear market, which sees a decrease of at least 20%, nor the significant decline in activity across a number of months during a recession. A correction can sometimes act as a forerunner to either a bear market or a recession, however.

Whilst corrections are often reported with similar negativity to crashes and recessions, they usually don’t warrant such pessimism. Corrections are an inevitability of the market: when stock value is going up, investors want in on the profits which could be made, leading to irrational exuberance and prices going above their underlying value. A correction in the price of a stock after a high period is often indicative of the stock’s true market value; as such, the correction may in fact indicate the market’s return to stability rather than a loss in value.

In this sense, corrections are healthy for the stock market, which is relatively volatile in the short term but in the long-term has a strong track record. They provide investors with the opportunity to see how comfortable they are with market risk and adjust or maintain their portfolio accordingly. There have been corrections in the past, and there will be more corrections in the future; unless it precipitates something more severe in the months ahead, the correction experienced at the beginning of February is no cause for panic.