Stock market corrections are a normal part of investing and growing your wealth over time. A stock market correction, defined as a 10% or more decline in broad indices, actually occurs on average once every two years.
Although there are a few approaches to dealing with a market correction, the best solution is to actually do nothing. Weathering asset volatility and sticking to a long-term plan is the absolute best way to achieve long-term investment success.
Less effective approaches include building a large cash position early on in the correction, properly diversifying your portfolio, and avoiding emotional, short-term trading.
A Look at Recent Stock Market Corrections
Market corrections have been fairly common over the past several decades. While it’s easy to look back and analyze each particular correction, staying invested throughout one is always a very difficult task.
Some more recent stock market corrections include:
- The 2000 dotcom bubble crash
- The 2008 great recession
- The 2010 European sovereign debt crisis
- 2015 stock market sell-off
- The 2018 cryptocurrency sell-off
- 2020 COVID-19 market crash
- 2022 Inflationary correction
How Much Does the Stock Market have to Drop to be Considered a Correction?
The textbook definition of a market correction is a drop in broad indices between 10% and 20%. Once the market in aggregate has dropped over 20%, it is considered a bear market.
The typical benchmark used for the broader stock market is the S&P 500 index in the US. In Canada, market indices include the S&P/TSX 60 index or the S&P/TSX Composite index.
Preparing for a stock market correction includes the following:
- Doing nothing
- Building a large cash position early on
- Properly diversifying your portfolio
- Avoiding short-term emotional trading
We will cover how you should prepare for a stock market correction in Canada below.
1. Doing Nothing During a Stock Market Correction
In theory, everyone knows that investors should buy low and sell high. When emotions get involved, particularly during a stock market correction, this becomes extremely difficult.
Investors who panic during short-term volatility may end up selling their assets at a discount. If this is for a lower price than those assets were purchased for, these investors end up selling high and buying low.
The importance of having a long-term investment plan in place cannot be understated. Unless you have an urgent liquidity need that coincides with a stock market correction, there is no reason to sell investments when markets are falling.
The S&P 500 index has returned an annualized 10.5% per year from 1957 to 2021. During this period of time, there have been a lot of corrections and recessions. Investors that sold off their investments during these market corrections would likely have a lower rate of return than the long-term average.
If you are investing with a long-term goal in mind, there is no reason to liquidate your portfolio holdings in the short term due to a correction. Assets should be sold as cash is needed to fund projects and expenses.
2. Building a Large Cash Position Early on
It is virtually impossible to be able to exactly predict when a market correction will begin. Retail investors are only a portion of overall stock market participants, alongside institutions and pension funds.
If you are able to somehow detect a stock market correction early on, selling off your investments and re-purchasing them at lower prices deep into the correction is a viable strategy. This ideal scenario is based on:
- Timing the market so that you sell your investments when they are at or near their short-term highs
- Timing the market so that you re-purchase your investments when they are at their lowest during the correction
Successfully executing both steps will increase your returns through the correction. Unfortunately, since they are both almost impossible to do, the next best thing is to stay invested throughout the correction.
3. Properly Diversifying your Portfolio
A well-constructed portfolio can outperform significantly during market corrections, especially if the correlations between your assets are well planned out.
Stocks and bonds are usually the main building blocks when putting together a portfolio. These two assets are usually negatively correlated, meaning that bonds go down when stocks go up, and vice versa.
Correlations between different investment asset classes can change over time. When markets are falling sharply during a recession or depression, correlations between asset classes tend to increase.
This is because everyone is panicking and liquidating all asset classes at once.
Alternatives: Market-Neutral Strategies
Within the alternative space, there is a particular strategy that shines during periods of market volatility: market-neutral strategies.
Market-neutral strategies are designed to provide investors with absolute returns, which are specific target returns regardless of any market conditions.
These target returns are usually fairly modest, and market-neutral strategies tend to have relatively low volatility of returns.
Other Ideas for Diversification
Although most assets increase in correlation, here are some additional ideas that may work to help portfolio performance within a correction:
- Gold
- Long-term government bonds
- Physical real estate
- Holding cash in USD versus other currencies
4. Avoiding Short-Term Emotional Trading
Short-term trading during a stock market correction usually takes place in two forms:
- Short-term trading into ideas that are doing well despite the correction
- Selling losing positions for fear of losing even more
Deciding to trade short-term winning ideas can be driven by wanting to make up for losses. If certain sectors or ideas have held up or performed well within a market correction, it may already be too late to invest in them at this point.
Conversely, if you hold several losing positions in your portfolio, a stock market correction is likely the time to invest more rather than sell.
The companies in your portfolio are now trading at a 10%+ discount, assuming nothing has materially changed with their long-term growth prospects.
As we mentioned in our first section, doing nothing during a stock market correction is likely the best approach for long-term investment
Conclusion
Tackling a stock market correction can be very difficult from an emotional standpoint, especially if you are invested prior to its beginning. The good news is that the best solution is also the easiest to implement – do nothing.
If you are adamant about doing something, consider building up a cash position very early on into the stock market correction.
Two other great strategies to follow are to make sure that you are properly diversified across asset classes and to avoid emotional trading.
It is crucial that you have a long-term financial plan in place that reflects your goals, objectives, and constraints.
