A Guide to Making the Most of Stock Market Corrections (2024)

While investing in the stock market, you must have heard the phrase “Stock market correction” often. For any investor, stock market corrections seem scary. The returns generated on your investments so far may witness a dip. Big corrections may even destroy your principal amount. But should you really worry about it? Or, is there any way to take advantage of the market falls?

In this blog, we learn more about stock correction, why it happens, and whether you should worry about it. We will also look at strategies you can use during a market correction for maximum gains.

What is Stock Market Correction?

A stock market correction refers to a sustained decline in a company’s stock price or the value of a market index. There’s no universally accepted definition of ‘market correction’.

However, a 10% drop in value from the recent market high is generally considered a correction. However, if there is a 20% drop, it is termed a bear market. These corrections are a natural part of the market and happen regularly to adjust the value of a stock or index that has increased unsustainably.

Why Does Market Correction Happen?

There are multiple reasons for the market corrections. But here are some of the common reasons for market corrections:

  • Overvaluation of Stocks: The main reason for market corrections is often the overvaluation of stocks. When stock prices rise due to market demand, they can become disconnected from the company’s value. This leads to overvalued prices. If investors notice that the stock prices are too high compared to the company’s earnings or other financial measures, they might start selling their stocks. This selling can cause the stock prices to fall back to a more reasonable level.
  • Profit Booking: When the market is doing well, many investors and traders get excited to make more money by booking profits. This excitement of selling can result in a correction as stock prices fall due to increased supply.
  • Panicked Selling: A stock market correction also occurs when a sudden event prompts widespread selling, often panic-driven. This can lead to herding behavior, where many investors tend to sell their holdings, leading to market price fluctuation and triggering a correction.

How do you know if a market correction is happening?

It is difficult to predict when the market correction will happen due to the multiple macro and microeconomic factors. However, some indicators can help you to track market correction.

Here are some of the indicators that can help you to identify when a market correction is happening:

  • 10% to 20% Drop: Market correction usually happens when there is a dip of 10% to 20% in the prices of stocks across various sectors and indices. Hence, if this is the dip pattern, the market is correcting.
  • Technical Analysis: You can also use money market indicators, such as technical analysis and chart patterns, to identify the market correction. Many stock analysts use these methods to predict and track market correction.
  • Stay Updated with Market News: If there is any negative news, economic shocks, or major events happening around the economy, then market correction can also happen.

Should You Worry About Stock Market Corrections?

To answer this question, let’s try to figure out if there is any pattern of stock market corrections and how the markets recovered from those falls.

Nifty 50 has seen 19 corrections (a market fall of 10%) in the last 16 years. And the average correction was about 14%.

Similarly, there have been 8 bear markets (20% market fall) in the last 25 years with one such event occurring every 3 years. The average time taken for the markets to hit the bottom was 8 months whereas, the longest time period was 20 months.

S.NoBear Market TimelineNifty50 Max DrawdownDays to bottom
1March 97 – April 9720.2%27
2August 97 – November 9838.3%481
3February 00 – September 0153.3%576
4January 04 – May 0435.9%129
5May 06 – June 0631.2%34
6January 08 – October 0864.6%293
7March 15 – February 1625.1%362
8January 20 – March 2039.6%64
Average drawdown and duration38.5%246

Does this scare you? Here’s some respite! Corrections don’t last forever. Often stock markets tend to recover within a few months of a steep correction. For example, on an average, a correction lasted for about 2 months before the upswing began.

An important takeaway is that corrections and bear markets are a regular part of investing in equity markets. And you can use these corrections to your advantage. How? Here are some strategies that will help.

1. Don’t Panic

Don’t feel horrified by the market corrections. Terrified investors often sell their investments at losses. Volatility is the risk you need to undertake to earn good returns in the market. If you cannot maintain your calm when the market corrects it is less likely that you will earn good returns in the long run.

So, here are a few tips that can help you survive a falling market.

  1. Avoid continuous monitoring of stock prices: When major indices are tanking, it’s likely that most of your stocks will also be in red. Checking their prices every now and then won’t help you much.
    Instead, try and remember the investment thesis on the basis of which you bought that stock in the first place. Then, see if those assumptions are still intact.
  2. Remind Yourself About Long-Term Financial Goals: The stock market has corrected multiple times in the past, however, in the long term it has offered great returns.
    For example, on the 17th of May 2004, the Sensex intraday low was 4,227 points. And exactly 18 years later, the Sensex was at over 52,00 points, thereby yielding a CAGR of 15%.So, always be clear about your time horizon and maintain the investment discipline to earn good returns.
  3. Keep Cash-In-Hand: This strategy is from the Warren Buffett school of investing. The idea here’s to keep some cash-in-hand for buying great businesses during these market dips. In the recent COVID-19 crash, investing more at a lower price would have given you wonderful returns.

2. Buy Stocks Of Strong Businesses

There is enough empirical evidence that strong businesses generate a mickle of wealth for investors when compared to mediocre businesses.

However, when a market correction takes place, you see a lot of investors gravitating towards the weaker businesses.

They did this under the hope that since they fell more than the stronger businesses, there is a lot more upside in these stocks.

The related data exhibited thus far does not support this. Therefore, when there is a market correction, investors should put their money in stronger and healthier businesses available at cheap valuations during these periods.

In other words, you would get better results if you apply the classic Buffett and Munger doctrine of buying great businesses at good prices than otherwise.

In addition to investing in these stocks, investors should show patience in riding out the market volatility – the mantra for wealth creation.

3. Unpunish Your Mistakes With Tax-Loss Harvesting

Many investors invest in low-quality stocks during bull cycles and are often stuck with these when the market corrects.

Now, when the dip comes, instead of holding onto these inefficient shares, you should explore getting rid of these stocks at a loss.

The resulting capital should be invested in high quality businesses which are available at relatively cheaper valuations.

As selling at a loss is a tough thing to do, one can gain comfort over the fact that a whole bunch of tax can be saved by setting off losses against the gains you made on other securities. This is formally called “tax loss harvesting”.

4. Build A Portfolio That Fits Your Risk Tolerance

A market correction serves as a wonderful opportunity to align your portfolio as per your goals and risk tolerance levels. During a bull run your portfolio starts getting skewed towards equities.

Your allocation starts moving swiftly away from your preferred 60:40 equity-debt ratio to a more equity heavy allocation of say, 75-25. Higher equity component increases the risk in your portfolio.

Thus, it’s highly recommended for you to review your asset allocation and rebalance your portfolio on a regular basis. Portfolio rebalancing will keep your portfolio’s risk under check and there would be lesser chances to make emotional investment decisions.

5. Continue Your SIPs

Systematic investment plans or SIPs work on the principle of averaging the cost of investments. When markets fall, mutual fund units become available at lower or discounted prices.

This zig-zag approach ensures that your acquisition price gets averaged over time. Thereby, creating wealth in the long run as the stock markets move up over the time.

To illustrate the importance of a market correction when investing via an SIP, here’s a quick simulation.

A Guide to Making the Most of Stock Market Corrections (1)

So, scenario one is the blue line denoting the reality of the stock market i.e., the Nifty values keep going up and down in bull and bear market cycles.

And scenario two is, let’s say an utopian world, a parallel universe where the stock markets never go down.

A Guide to Making the Most of Stock Market Corrections (2)

We have mapped data for a 16-year period from 2006 to 2021.

For instance, if we invest Rs 10,000 monthly SIP on the actual NIFTY 50 TRI, we get an accumulation of over 59 lakh in 16 years at a CAGR of 14.3%.

On the other hand, had we relied on our no-downside imaginary index, we would have accumulated a lower corpus of Rs 52 lakh at a CAGR of 12.9%.

A Guide to Making the Most of Stock Market Corrections (3)

Here’s what you glean from the scenarios- these corrections and bear market moments have helped investors who remained invested through the turmoil, collect more mutual fund units and a bigger corpus over the long run.

Conclusion

Stock markets are definitely volatile, and any kind of correction can sweat any investor. But the good news is that corrections create a window of financial opportunity for the investors. Stock market corrections help us accumulate mutual fund units or stocks at a discounted price.

Since market corrections are common and natural, a better way to deal with them is to be disciplined with your investments and follow your asset allocation. Don’t panic sell when the stock market is going down. Have the patience to ride out the market volatility. Invest according to your time horizon and build a portfolio that fits your risk appetite.

A Guide to Making the Most of Stock Market Corrections (2024)
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