Many of us have heard of the term “stock market,” but not everyone knows how it works.
A stock market is a marketplace where buying, selling, and issuance of stocks, securities, and other financial instruments takes place. Stock markets are also referred to as share markets or equity markets.
Stocks are types of financial instruments that signify ownership in a company and represents a claim on part of the company’s earnings and assets. A company lists shares of its stock on a stock market through a process known as an initial public offering (IPO).
Companies list their stocks in order to raise money to expand their businesses by selling the shares to investors. Once a company goes public, its shares are freely bought and sold on the stock market by the public.
Stock markets enable buyers and sellers to negotiate prices of various stocks and make trades. They also track the supply and demand of all listed stocks. The need for the general investing public to profit from stocks, and companies to raise extra funds, is what keeps stock markets alive.
However, there is nothing scarier to stock traders than watching the market go down day after day and the value of their portfolios decrease.
As an investor, you ought to always work out how much money is worth risking, particularly in times like the present when the stock market has moved further into the overbought territory.
In this article, we will discuss what a stock market correction is, how to prepare for a correction, and how you should invest your money during a correction.
What is a stock market correction?
A stock market correction is a decline of 10% or higher in the price of a stock from its most recent all-time high. If the price falls by 20% or higher, it is then called a bear market.
On average, corrections occur about every 8 to 12 months and tend to last about 54 days. The U.S. had 37 stock market corrections between 1980 to 2018.
Corrections can happen to individual stocks, specific indexes, or one of the stock markets such as the Nasdaq, New York Stock Exchange, etc.
Preparing for a correction
Although it is good for any long-term bull stock market to pull back a bit in order to allow traders to feel as if they are getting some gains from their investment, drops of large magnitude can be unnerving. However, there are some simple things that investors can do to prepare a market downturn. Let’s take a look at a few of them.
- Develop a plan for your investments
Identifying your investment goals is always a great idea whether or not the stock market is in a bull market, a bear market, or a correction. Having a plan for your short or long-term investments may offer you some assurance and help you to respond to market changes with logic instead of emotion.
- Analyze your portfolio
Next, look at how your stock portfolio matches with your investment plan. Identify and sell stocks that have huge loss potential to protect your portfolio in the event of market correction.
- Keep your cool
Finally, always try to separate your emotions from your investment decision-making process. Corrections are painful as the value of your portfolio could plummet and wipe out hard-earned gains in a matter of days or hours.
Painful as the prospect is, you should resist the urge of selling off every stock that is declining rapidly. Many analysts often speculate on market changes, but it is not always good to take those predictions too seriously as some may lead you to panic-sell.
Tips for investing during a correction
Although it’s not easy to predict when the next stock market correction will happen, the tips for investing during one haven’t changed in the last couple of decades. Here are a few tips to help you invest in stocks during a market correction.
- Invest in good companies
Put your money in stocks of good companies that generate attractive returns on equity, real profits, and those with low-to-moderate debt-to-equity ratios. You also ought to know the long-term prospects of the company whose shares you intend to buy, its competitors as well as its place in the overall industry.
Stocks of companies with good business attributes tend to withstand a correction and are more likely to recover even if the market slides into bear territory.
- Don’t overtrade
Overtrading is excessive selling and buying of shares by stock traders. Such behavior can adversely affect your stock portfolio, particularly during market corrections. A disciplined investor should always try to retain a well-balanced approach without overtrading or over risking your account.
- Avoid buying stocks on margin
On the surface, borrowing money from your brokerage in a margin account in order to buy more shares might appear to be a great way to turn a huge profit. But the reality is that trading on margin exposes you to extra risk during a stock market correction.
Moreover, it could cost you thousands of dollars in interest on your brokerage account and even lead to personal bankruptcy.
Final thoughts
If you are going to invest in the stock market, it is important to understand that a stock market correction is an inevitable part of investing.
When stock prices begin heading south, some investors tend to react quickly and make bad decisions that hurt end up hurting their financial conditions.
But those who take steps to prepare their portfolios generally are better able to control their emotions when markets fall apart.