What is a market correction?

You may have heard warnings about the dreaded 'stock market correction' in your investing journey. However, there's nothing to fear about this common share market phenomenon. 

By the end of this article, you may even see market corrections as an opportunity to buy the shares you love at bargain prices.

What is a stock market correction?

In finance, a market correction typically occurs when the price of a major share market index falls by at least 10% from its most recent high.

Although we're talking specifically about stock markets in this article, corrections can also occur in other markets, like those for bonds, property, or currencies. Individual assets, like the shares of a specific company, can also suffer corrections if their stock price falls more than 10% from their peak.

How is a correction different to a bear market?

A price fall is usually relatively shallow and short-lived in a market correction. After a brief period, the market recovers and then goes on to post new and ever more impressive highs.

However, if the market doesn't recover and prices continue to fall over a more extended period (think months or even years), then a market correction can metastasise into a full-blown bear market.

A bear market occurs when prices fall by more than 20% from their highs and trend down over a sustained period of time.

For example, during the 2007–2009 bear market sparked by the global financial crisis, the S&P/ASX 200 Index (ASX: XJO) shed more than 50% of its value over 18 months.

It's also important to note that a correction, crash, or bear market doesn't affect all shares equally.

Higher-risk, speculative investments like junior companies or growth shares may see their stock prices fall by well above 10% or 20% in a correction or bear market. This is because many investors will sell their high-risk stocks and buy less risky, stable companies (like blue-chip shares) in a crisis.

What about a stock market crash?

A crash packs the same punch as a bear market – but gets it done much quicker.

In a crash, stock prices also usually dive by more than 20% (which is more severe than a correction), but it all takes place over weeks – or sometimes even just a few days.

A crash can also trigger a longer-term bear market, or the market may recover quickly. For example, there was a speedy price rebound after the COVID-19 crash in March 2020. So fast, in fact, that by June 2020, the ASX was back in bull market territory again after rising more than 20% from its lows.

What causes a market correction?

There can be many reasons why a market correction might occur.

For example, it may be caused by a macroeconomic shock – like a sudden rise in the price of oil or other widely used commodities. This can have far-reaching impacts across the whole global economy and could lead to a sudden drop in share prices.

A correction may also occur if there is a general souring in the economic outlook. For example, current global recession fears are due to a confluence of factors, including rising interest rates, high inflation, supply chain issues, and the lingering effects of the COVID-19 pandemic.

These factors will likely reduce the economy's output, causing a broad sell-off in equities and a general market decline.

A destabilising event, like a war or a pandemic, may also cause a sharp sell-off in shares, as we have seen recently.

Other times, it may be difficult to discern the exact reason for the correction. It may just be that the market has become 'overheated' and prices have been pushed up too quickly.

If there is a general sense that shares have become overvalued, investors may decide en masse to sell their holdings and realise some profits while prices are most favourable. If enough investors do this at once, it can also lead to a correction.

How often do market corrections occur?

Corrections occur relatively frequently and should be considered normal in a healthy financial market.

Sometimes, investors may become overexuberant in response to a positive piece of news and might bid up share prices to unsustainably high levels. A correction may be needed to bring prices back to more realistic levels in these cases.

This is a normal part of the price discovery function of any financial market – and it's why it's referred to as a 'correction' in the first place. When share prices become too overvalued, they need to be 'corrected' – that is, they need to be brought back in line with the market's underlying intrinsic value.

There are no hard and fast rules about the frequency of market corrections, but most sources on the web will tell you that they occur about once every two years on average – and perhaps even more frequently than that.

How long do they usually last?

One of the defining qualities of a market correction is that it is usually a relatively brief and mild pullback in prices.

Any more severe, and it would turn into a crash – as we saw in the early days of COVID. Any longer, it will likely turn into a bear market.

This means corrections typically only last a few weeks or months before buying activity picks up again and market prices recover.

For example, the ASX 200 last suffered a correction in October 2023, when investors were anxious about the escalating conflict between Israel and Hamas and its potential to spark a broader war in the Middle East. 

However, by January 2024, prices had already recovered to their previous levels, and the ASX 200 went on to post new all-time highs in March 2024.

Are we currently in a market correction?

The short answer is no. However, we recently emerged from one.

As of March 2024, the ASX 200 is hovering around fresh all-time highs. After suffering a correction in late 2023, the market has rebounded strongly. 

Despite ongoing conflicts in Europe and the Middle East, easing inflation and the prospect of interest rate cuts later in the year make investors more optimistic about the economic outlook.

Will there be another?

Absolutely.

Regular corrections are part of the lifecycle of a healthy financial market. They are simply a natural outcome of the perennial tug-of-war between supply and demand that determines an asset's real-time price.

Sometimes, corrections will occur in response to unforeseen shocks to our economic, political, or natural environments. Other times, it is just an overheated market cooling down.

Even if we can't predict the reason for the next market correction, we can be absolutely sure that there will be one.

How to prepare for a stock market correction

The best way to prepare for a market correction is not to see it as a catastrophe. Instead, view it as an opportunity to buy shares in the companies you love at significantly discounted prices (sometimes called buying the dip).

Sure, it's no fun when your share portfolio is a sea of red, but if you believe in the long-term prospects of the companies you invest in, you should have faith that their share prices will eventually recover and post new highs.

This makes a correction an ideal time to start buying. As Warren Buffett once famously quipped, "Be fearful when others are greedy, and greedy when others are fearful".

That being said, you can still take some steps to reduce your portfolio's volatility and protect it against sharp losses during a market correction or downturn. This is a particularly advisable investment strategy if your risk tolerance is low.

For example, you can shore up your investment portfolio by buying defensive shares and safe-haven assets like gold and bonds. These assets tend to preserve their value in a market downturn and can offset some of the losses you may experience on the riskier shares in your portfolio.