A stock market correction is a moderate decline in stock prices, generally following a period of gains in a bull market. A stock market correction is different than a crash, which is greater in magnitude, and is also not the same as a bear market, which is a deeper and more prolonged period of declining prices.
While many who work on Wall Street and in the financial news media may react to corrections with panic and selling, for long-term investors, stock market corrections can be excellent buying opportunities.
Definition of a stock market correction
A stock market correction is generally defined as a negative movement in major stock indexes -- particularly the Dow Jones Industrial Average, S&P 500, or Nasdaq Composite -- of 10% or more from recent highs. Generally speaking, corrections occur during bull markets, or uptrends in the stock market.
For example, if a hypothetical stock index peaked at 1,000 points after a long upward trend, a pullback to 900 points would be considered a correction.
Including the most recent correction in February 2018, there have been 37 stock market corrections since 1980. So, it's fair to say that a stock market correction is a relatively common occurrence, happening about once per year on average, although there can be longer periods of time without a correction.
Example of a stock market correction
One great textbook example of a stock market correction occurred in early 2016. The S&P 500 had peaked at about 2,109 points on Nov. 3, 2015, and by Feb. 11 had fallen to 1,829, a decrease of 13.3%. The drop wasn't sudden, nor was it terribly dramatic, and was a part of the general uptrend in the stock market that started in 2009.
How a correction is different from a stock market crash or bear market
The term "stock market correction" is often used interchangeably with terms like "stock market crash" or "bear market." However, there are some key differences between the three.
A stock market crash isn't necessarily defined by the percentage drop. Rather, a crash is characterized as a sudden or deep drop. Black Monday in 1987, when the S&P 500 shed about 22% of its value in a single day is a good example of a stock market crash. The near collapse of the U.S. financial system in 2008 and the 34% drop during September and October of that year can also be considered a crash.
On the other hand, a bear market is a deeper drop than a correction, generally defined as a drop of more than 20% from the highs over a time period of two months or more, although the exact definition depends on whom you ask.
Here's a good example of the difference between all three of these terms and their proper usage. The period between October 2007 and March 2009 when the Dow Jones Industrial Average fell 54% was the most recent bear market. The aforementioned two-month period where the market fell sharply was a crash. And when the market fell by roughly 10% of its 2007 highs by February 2008, the stock market was in a correction at that point.
Why a correction is an opportunity for long-term investors
One key point to remember is that a correction is a part of a healthy stock market. Markets can't simply go up forever, and while it can be scary to watch the value of your portfolio drop by 10% or more, corrections shouldn't be a cause for panic.
Instead, corrections should be approached as long-term buying opportunities. Think of it this way -- if you were shopping at your favorite store, and everything was suddenly market down by 10%, what would you do? Would you panic and run away? Of course not.
The same logic applies here, from a long-term perspective. Corrections can be excellent opportunities to add great stocks to your portfolio for significantly less than they cost just weeks before. During the early 2016 crash I mentioned earlier, the banking sector got particularly clobbered, and there were a ton of great opportunities for investors focused on the long haul, such as Bank of America at $11 (currently $31) or J.P Morgan Chase at $53 (currently $110). Even if you had bought a simple S&P 500 index fund during that correction, you would be sitting on a gain of more than 40%.
The point is that while we have no idea what stocks will do in the short term, it's a safe bet that the stock market and many rock-solid individual companies will do just fine over the long run. So, the next time a correction comes along, don't panic -- take advantage.
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