Put Stock Market Corrections in Perspective to Avoid Harmful Reactions

During and after a 10 percent stock market correction, it is natural to ask whether the correction will deepen or not. We are wired for fight or flight and about twice as sensitive to losses as gains. Those more prone to act on instinct are vulnerable to selling stocks. This can result in missed gains during the ensuing years.

Reviewing past corrections, and the gains that follow, can help short-circuit those instincts.

Historical odds of a 10% correction are about 50/50.

Since 1950 the S&P 500 declined more than 10% in about half the years. This past 10.2% drop took little more than two weeks and was abnormally fast by historical standards. The typical correction, based on data from Yardeni Research, Inc., took more than 3 months and resulted in a drop of 14.5%. So this year’s correction could be considered short and shallow. Perhaps another correction will occur this year. It would not be unprecedented. Two corrections in one year occurred in 2015, 1990, and 1971.

A visual of corrections is provided by Dimensional Investment Advisors (DFA). They used the Russell 3000. The Russell 3000 is a more comprehensive index with small and mid-sized companies in addition to the large companies which dominate the S&P 500. It too shows more than half the years have corrections of 10% or more. Interestingly, performance was positive in 86% of the years, 32 years out of the 37, DFA examined despite the declines within years.

Market Correction

Annual performance is shown as blue columns, maximum declines within the year are shown as red lines, and maximum increases within the year are shown as black lines. US Market is measured by the Russell 3000 Index. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Source: Dimensional Fund Advisors.

Selling after a 10% correction has already occurred is generally not a good idea.

S&P 500 Index data provided by Standard & Poor’s Index Services Group. Declines are defined as peak-to-trough cumulative losses that result in a cumulative drop of at least 10%. The trough is defined as the last negative day before an uptick (a day with a positive return). Annualized compound returns are computed after passing the 10% decline threshold and averaged across all 10% declines.

Corrections have not reliably foreshadowed poor future market performance. Sure, some corrections have marked the beginning of bear market declines greater than 20%. But looking beyond calendar years and back to 1926, stocks are more likely to be higher soon after a correction.

The chart above shows one year later, the S&P 500 Index was up 12.0% from correction troughs. Three years later the index was up 8.9% and five years later the index was up 10.1%. Of the 152 corrections DFA studied, stocks rose 9.3%. This is below average one and three year performance after corrections. Why? Corrections sometimes coincide with bad news. Investors demand more compensation (higher returns) for bearing risk when markets are perceived to be riskier because of bad news.

The difficulty of getting back in to the market after a correction.

It is hard to identify in advance which days the market will shoot up and which days it will not. Vanguard’s graph below shows the best and worst trading days often happen close together. Those who sell on down days (shown in red) risk missing the best days (shown in dark blue).

Source: Vanguard

Have a plan for corrections.

While corrections may arouse deep-seated instincts, reacting emotionally and changing long-term investment strategies could prove more harmful than helpful. Having a well-thought-out investment plan suited to your situation can short-circuit your baser instincts. Call for a complimentary portfolio check-up to make sure you are on track to successfully meet your financial goals.

This blog entry is distributed for educational purposes and should not be considered investment, financial, or tax advice. Investment decisions should be based on your personal financial situation. Statements of future expectations, estimates or projections, and other forward-looking statements are based on available information believed to be reliable, but the accuracy of such information cannot be guaranteed. These statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results and no representation is made that any stated results will be replicated. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Copyright © 2018, Granite Hill Capital Management, LLC.

About 

Investment Advisor and Financial Planner

Contact me if you need help: (1) Simplifying your portfolio by sorting through what you’ve got and finding where adjustments may be warranted, (2) Reviewing your investment risks and expected returns, (3) Allocating your investments wisely among different accounts, and (4) Creating a plan that clearly integrates your resources with your goals.

Owner and Founder of Granite Hill Capital

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.