Although it can be incredibly stressful for investors, volatility is a normal part of a well-functioning share market.
In this article, we look at some of the terminology used to describe falls in share prices – in particular, market corrections and market crashes.
What is a market correction?
A market correction has quite a technical definition in finance. It refers to a price decline of between 10% and 20% from a previous high of an individual share, industry sector, or even the share market as a whole. It is usually relatively short-term in nature, taking place over the course of two to four months.
For shareholders, any sizeable loss in value can be a nerve-racking experience. But it's important to remember that these sorts of price pullbacks are a normal part of the cycle of healthy financial markets.
Corrections typically occur when prices have risen too high, too quickly. When this happens, investors may be more likely to take some of their profits off the table by selling their shares, which in turn causes prices to decline.
If enough investors decide to sell their shares simultaneously, it can push prices down substantially, potentially leading to a correction.
A correction can be broad in scope, affecting the entire market, limited to a particular industry or even just a single share.
For example, a poor financial result on the part of a company can cause its shareholders to suddenly offload their shares en masse, which may, in turn, cause its share price to drop by more than 10% in a fairly short period of time (and enter correction territory).
This happens because the market consensus of the company's valuation quickly changes in light of the new information – namely, its poor financial result. Other negative news can also lead to share price corrections, such as evidence of company mismanagement, legal issues, changes in industry regulations, or profit downgrades.
Whatever the cause, you can think of these sudden drops in price as the market 'correcting' a situation where a company's shares have become too expensive relative to their underlying financial performance. So, their prices fall in line with the market's updated consensus view of their intrinsic value.
When was the last market correction?
In October 2023, the benchmark S&P/ASX 200 Index (ASX: XJO) – which tracks the value of the 200 largest companies on the ASX by market capitalisation – officially entered correction territory. This was due in large part to anxieties about the escalating conflict between Israel and Hamas and the possibility of a broader war in the Middle East.
By January 2024, the index had largely recovered (and went on to post fresh all-time highs in March), making this an almost textbook definition of a correction: a short-lived drop in prices of between 10% and 20% from a previous high.
How to recognise a market correction versus a dip
A company's share price dip is generally only a relatively small, brief drop in price below an otherwise steady long-term uptrend. Because the underlying demand for the company's shares remains strong, the share price tends to recover and continue upward quickly.
Many investors try to 'time the market' by looking out for dips in share prices and using these as opportunities to buy them cheaply. You'll often hear this investment strategy referred to as buying the dip.
However, this is incredibly difficult to do consistently because you never know ahead of time whether a price drop is just a brief dip or the beginning of a more prolonged correction – or even an all-out crash.
What is a stock market crash, and how is it different from a correction?
A stock market crash is an extremely sudden and severe drop in prices. If you thought a 10% price drop was terrible – brace yourself. In a market crash, the share prices of some companies could plunge close to zero!
Crashes are also very quick, sometimes taking place over a matter of days or weeks. Many share markets worldwide suffered large, swift crashes at the beginning of the COVID-19 pandemic. For example, the ASX 200 index shed more than 30% of its value in less than a month in March 2020, as cities across the globe went into lockdown and international borders were slammed shut.
One of the most famous stock market crashes was the Wall Street crash of 1929, which precipitated the Great Depression. The excesses of the Roaring Twenties led to heightened speculation on the share market, driving prices up to unsustainable levels. Eventually, the bubble burst, resulting in some of the most significant single-day market declines in Wall Street history.
Crashes are different to corrections because of their severity and swiftness. While corrections describe losses in value of between 10% and 20% over the course of a few months, crashes can result in much larger declines above 20% and often play out over just a few days.
What about a bear market?
A bear market describes a lengthy period in which there is a general slowdown in the economy, and the share market suffers a sustained loss in value. Investor sentiment tends to be overly pessimistic during bear markets.
Despite its severity, the Wall Street crash of 1929 actually only marked the very beginning of a much longer bear market. By July 1932, the Dow Jones Industrial Average (INDEXDJX: .DJI) had shed almost 90% of its value – and it didn't return to its 1929 highs for more than two decades, until November 1954!
A bear market differs from a correction because prices drop by more than 20%. However, it is also different from a crash because it takes place over a much longer period of time. A crash or correction can easily turn into a bear market if they become severe and long-lasting enough.
The opposite of a bear market is a bull market, which describes a period in which favourable economic conditions and share prices generally trend higher. Investors generally tend to feel optimistic during bull markets.
The names come from the fact that a bull thrusts its horns upwards while a bear swipes its claws downwards. These are used as visual metaphors to describe the direction of market trends.
Can you protect your portfolio from a market correction?
It is next to impossible to fully protect yourself from the effects of a market correction. Unfortunately, volatility is simply a natural part of the share market. But there are steps you can take to reduce the severity of its impact on your portfolio.
One of the most important things you can do is diversify your investments across multiple companies and industry sectors. That way, if certain companies or industries suffer corrections, some of your losses may be offset by gains made elsewhere.
Another thing you can do is follow a dollar-cost averaging (DCA) investment strategy.
This involves breaking up the amount you want to invest into smaller pieces and investing them periodically – say once a week – over time. Dollar-cost averaging takes much of the guesswork out of investing, as it relies on making regular, consistent investments rather than trying to time the market.
This is a particularly effective strategy to adopt when markets are volatile, as it means you end up averaging out your purchase price amid the highs and lows.
The longer you keep a strategy like this up, the less effect short-term movements in share prices – like crashes or corrections – will have on the value of your portfolio. Just be mindful that the transaction fees on all those individual trades will impact your returns somewhat.
Key takeaways
Although market corrections and crashes can scare shareholders, they are a normal part of financial markets. The best thing you can do in a crash is not panic. Try to see it as an opportunity to pick up extra shares at bargain prices.
Although you can't protect your portfolio fully against the effects of market volatility, there are several steps you can take to reduce its severity. Hold a diversified portfolio of investments across multiple companies and industries, and consider a dollar-cost averaging approach, as this can help smooth your returns over time.
Frequently Asked Questions
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A market correction refers to a drop in share prices between 10% and 20% from a previous high, typically over a relatively short time frame (say a few months). Corrections happen quite often and are a normal part of a healthy share market. They can occur when demand for shares has pushed share prices to unsustainably high levels. In these cases, investors sell their shares to take some profit off the table, and share prices fall back to align with their intrinsic values.
A recession, on the other hand, refers to a decrease in economic output. The technical definition of a recession is hotly debated – particularly by governments who might be in one. But a good rule of thumb is that a recession refers to a decline in (inflation-adjusted) gross domestic product (GDP) in at least two consecutive quarters. However, because a recession reflects a slowdown in the broader economy, it can cause a market correction. When the economic outlook becomes gloomy, investors tend to sell shares in favour of safe haven assets.
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A market correction doesn't feel great, as an investor. No one wants to see the value of their share portfolio decline, after all! However – although stressful – market corrections are entirely normal and actually happen pretty regularly. Usually, they are a result of prices rising to unsustainably high levels. In these cases, investors may decide to take some of their profits off the table, causing prices to decline. In other words, the market 'corrects' a situation where prices have risen too quickly and caused stocks to become overvalued.
Corrections can also be triggered by changes in macroeconomic factors, like interest rates. This may cause investors and market analysts to reassess the valuations they originally placed on a company or the share market in general. In either case, you shouldn't fear a correction -- look at it as an opportunity to invest at more reasonable prices. There are also steps you can take to reduce the impact a market correction has on your portfolio, such as diversifying your share portfolio and employing a dollar-cost averaging investment strategy.
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Sometimes referred to as a retracement or a consolidation, a 'pullback' is a small drop in prices during an otherwise mostly uninterrupted uptrend. A pullback is much milder and shorter in duration than a market correction. For example, a pullback may be a drop in price of a few percentage points from a recent peak, occurring over the course of a couple of days, after which prices continue to rise.
You might have heard the phrase 'buying the dip' being bandied about in investing circles. This is when traders try to take advantage of these small pullbacks in prices by buying shares at these moments to maximise their profits when prices eventually continue their uptrend. While this sounds great in theory, in practice, timing the market is very difficult to do consistently.
A market correction is more severe and long-lasting than a pullback. It represents a drop in prices of between 10% and 20%, which can happen over the course of a few months.
