For Wall Street and the investment community, 2020 is a year that won't soon be forgotten. The uncertainty and panic caused by the coronavirus disease 2019 (COVID-19) pandemic changed societal habits, cost over 20 million Americans their jobs (if even temporarily), and pushed the U.S. economy into recession for the first time in 11 years.
The pandemic also did quite the number on the stock market, with investors navigating their way through the steepest and quickest bear market correction in history, as well as the most ferocious rebound from a bear market bottom of all time.
Though the vacillations we've witnessed in the stock market of late are pretty uncommon, there are seven things about stock market crashes and corrections you should know.
1. Crashes and corrections happen frequently
First of all, get used to the fact that the stock market has big moves lower from time to time. Though investors can sometimes become complacent with a melt-up in equity valuations, stock market corrections and crashes are quite common.
According to data provided by stock market analytics company Yardeni Research, there have been 38 separate stock market corrections in the benchmark S&P 500 (SNPINDEX:^GSPC) of at least 10% (unrounded) since the beginning of 1950. For you math-phobes, this works out to a correction every 1.84 years. Smaller moves lower of 5% to 9.9% are even more common.
For those curious, a move lower of at least 30%, like we witnessed in March, occurs, on average, once every decade.
2. Corrections are impossible to predict
Another must-know of stock market crashes and corrections is that they're impossible to predict. This is to say that we're never going to know ahead of time:
- When a correction will occur;
- How steep said correction will be;
- How long the correction will last; or
- What'll cause the correction or crash in the first place.
This is a roundabout way of saying that trying to time short-term moves in the stock market can't be done with any consistency or accuracy over the long run.
3. They don't last very long
Historically, stock market crashes and corrections don't last very long. Even though a big move lower manifests every 1.84 years on average, the majority of corrections are over in well under four calendar months. In total, 24 of the past 38 official corrections have lasted for 104 or fewer calendar days, with only seven corrections since 1950 lasting longer than one year.
Even when adding in those extra-long crashes and corrections, the average length only jumps to 188.6 calendar days, or roughly six months. Comparatively, bull market expansions are measured in years, not months.
4. Emotions tend to overshoot in both directions
If you're wondering why stock market crashes and corrections can be so violent but are often short-lived, look no further than emotional investing.
Even if you're able to remove your emotions when investing, there are more than enough short-term traders and investment firms out there that can influence equity movements in the short run. In fact, it's not uncommon for short-term traders to overshoot to both the downside and upside when big momentum moves take hold.
5. Short-term traders get clobbered by crashes and corrections
One of the most important things to realize about stock market corrections and crashes is that it's only short-term traders and those who've invested using margin that are getting hammered by these moves lower.
As noted, it's impossible to predict the short-term movements in the market with any accuracy. This means near-sighted investors could get stuck in money-losing positions, and traders who've used margin in an attempt to bolster their gains could see their losses magnified. If we've learned anything in 2020, it's that the market can stay irrational longer than you can stay solvent.
6. They're the perfect time to review your investment theses
Regardless of whether a big crash or methodical correction occurs, notable moves lower in the stock market are an excellent time to reevaluate your holdings.
To be clear, running for the hills is almost always a very poor idea. In many instances, your initial investment thesis in a stock is going to be unaffected by a swoon in the S&P 500. By this I mean the reason you initially bought into a stock should remain the same.
For example, I've been holding shares of Bank of America (NYSE:BAC) for nearly nine years, which means I've held through five official corrections in the S&P 500 of at least 10%, as well as seven additional corrections ranging between 5.8% and 9.8% since I took my stake. None of these moves lower in the stock market have had any bearing on my initial investment thesis in Bank of America. It's still inexpensive relative to its book value, has cleaned up its credit quality immensely, and has done an excellent job cutting noninterest expenses. Chances are that your portfolio is filled with companies whose operations are unaffected by crashes or corrections.
7. Buying into a stock market crash/correction is a prudent move
Finally, but perhaps most important of all, know that buying during any stock market crash or correction is going to be a smart move. That's because every single correction or crash in history has eventually been put into the rearview mirror by a bull market rally. The key here is that investors have to be patient and allow operating earnings growth to do its thing. If your time horizon is too short, no guarantees can be made.
It's also a good time to consider buying into growth and/or dividend stocks. Growth stocks usually benefit when interest rates are pushed lower by a dovish Federal Reserve. That's because they can borrow cheaply, allowing for growth stocks to rapidly expand. Meanwhile, dividend stocks have historically run circles around their non-dividend counterparts.
The point is, a stock market crash or correction is actually a blessing in disguise for long-term investors.