What is a stock market correction?

Ever since Charles Dow published the first stock index, originally known as the Dow Jones Railroad Average, in 1884, investors have been obsessed with tracking and quantifying markets. And for the most part, the U.S. stock market has gone up. Today, the S&P 500 is considered the benchmark index, and from its inception in 1926 to Dec. 31, 2021, its average annualized return is just over 10%.

But as everybody knows, the market doesn’t always go up, especially during times of volatility, and it is during those times when you will often hear different terms to try and describe what is happening.

Perhaps the most well-known is “bear market.” A bear market occurs when the S&P 500 drops 20% or more from a recent high. Another term that gets thrown around a lot is “pullback.” Generally, a retreat of 5% to 10% from recent highs is considered a market pullback.

And that brings us to a term that is more substantial than a pullback but not as severe as a bear market: a correction. A correction occurs when the stock market drops 10% to 20% from its recent highs. Once it drops more than 20%, we enter bear market territory.

Corrections are a fairly common occurrence in the stock market; since the turn of the century, we’ve already had 11 of them. And though every bear market has to start with a correction, not every correction leads to a bear market. Of those 11 corrections, only three – in 2000, 2007 and 2020 – turned into full-blown bear markets.

Who decides how much a correction is? That is a great question, but unfortunately, one without an answer. No group or organization has ever officially designated what constitutes a pullback, a correction or a bear market and it’s a great reminder that all the percentages associated with these terms are arbitrary.

That’s because not only can the stock market – as measured by the S&P 500 – have pullbacks, corrections and bear markets, but so can individual stocks, sectors and even asset classes.

For example, if the S&P 500 drops 12%, putting it into a correction, but you are invested solely in tech stocks, which, as a sector are underperforming, your portfolio could already have gone past a correction and into bear market territory. Conversely, if we enter into a bear market, your portfolio may be down less if it is well-diversified, because it may include allocations across sectors and asset classes that could be outperforming the stock market.

That is why it is in your best interest to maintain a long-term outlook when it comes to your investment portfolio and avoid making short-term changes when you hear the media talk about stock market corrections. Doing so is a form of market timing. No one has ever demonstrated an ability to buy and sell at the right times consistently over any meaningful length of time, including professionals.

Not only do you have to know when to sell, but you have to know when to get back in. And in some cases, a market correction can happen so fast that by the time you realize it is happening, and sell all your stocks, the market has already recovered. That’s what happened in early 2018 when the market had a correction that lasted less than two weeks.

Here at Edelman Financial Engines, we reject tactics like market timing, sector rotation, trend analysis and investing fads, both new and old. Instead, we construct diversified portfolios for our clients, designed to adapt to changing market conditions, with a focus on long-term performance.