Panic has hit Wall Street and Main Street -- or at least that's what the financial headlines would lead you to believe.
Last week the Dow Jones Industrial Average, broad-based S&P 500, and technology-heavy Nasdaq Composite suffered through their worst week in years. The Dow shed more than 1,000 points, the Nasdaq dipped more than 340 points, and the S&P 500 fell around 120 points. Unless you were a noted short-seller of stocks, it probably wasn't a good week.
The closing price for the Dow also signaled its first official correction since 2011. A stock market correction is defined as a drop of at least 10% or more for an index or stock from its recent high. With the Dow sitting almost 1,900 points off its all-time high set back in May, the Dow has now shed 10.3% from its highs, officially putting the widely followed index in correction territory.
What you should know about a stock market correction
However, a stock market correction isn't necessarily a bad thing depending on the context you view the correction from. Here are six important things you really should know about a stock market correction.
1. Stock market corrections happen often
The first thing you should know is that stock market corrections happen -- and fairly often. The U.S. economy naturally peaks and troughs over time, and in response the stock market will also have its peaks and troughs.
According to investment firm Deutsche Bank, the stock market, on average, has a correction every 357 days, or about once a year. Our last correction was nearly 1,000 days ago, the third-longest streak on record. For those curious, we went around 1,800 days without a correction in the mid-1990s. Long story short, corrections are an inevitable part of stock ownership, and there's nothing you can do as an individual investor to stop a correction from occurring.
2. Stock market corrections rarely last long
In a broader context, while a stock market correction is an inevitable part of stock ownership, corrections last for a shorter period of time than bull markets.
Based on research conducted by John Prestbo at MarketWatch on the Dow between 1945 and 2013, Prestbo determined that the average correction (which worked out to 13.3%) lasted a mere 71.6 trading days, or about 14 calendar weeks. Not counting our most-recent dip in the Dow, corrections in this century have averaged 87.8 trading days, or about 17 calendar weeks. In other words, stock market corrections often tend to be on the order of a few weeks to two quarters in length.
3. We can't predict what'll cause a stock market correction
A stock market correction may be inevitable, but one thing they aren't is predictable.
Stock market corrections could come about within any timeframe (every few months or after multiple years), and they can be caused by a variety of issues. For instance, we now know the impetus for the Great Recession was the bursting of the housing bubble caused by an implosion of subprime mortgages. But, how many people were echoing that subprime was a problem in 2006 or 2007? The answer is very few people were. Predicting the root cause of the next correction on a regular basis just isn't possible.
4. Stock market corrections only matter if you're a short-term trader
Another important point you should realize is that stock market corrections really aren't an issue if you remain focused on the long-term with retirement as your goal. The only people who should be worried when corrections roll around are those who've geared their trading around the short-term, or those who've heavily leveraged their account with the use of margin.
Traders using margin could see their losses magnified in a downturn (just as their gains were pumped up during the bull market), while active traders and day-traders could see their losses and trading costs build during a correction. Maintaining a long-term view has been the smartest way to invest in stocks throughout history – and it also happens to be a recipe for a good night's sleep.
5. They're a great time to buy high-quality stocks at a bargain
For the long-term investor, a stock market correction is often a great time to pick up high-quality companies at an attractive valuation.
Take Gilead Sciences (NASDAQ: GILD), the maker of revolutionary once-daily hepatitis C therapies Harvoni and Sovaldi, as an example. A stock market correction isn't going to impede the desire of HCV patients to get treated – there are an estimate 3.2 million HCV patients in the U.S. per the Centers for Disease Control and Prevention -- meaning Gilead could still reap $10-plus billion in sales combined from these therapies, as well as ample profits, regardless of how the stock market is doing. Yet, Gilead shares are off approximately 15% from their all-time high. Perhaps it's time for investors to take a closer look?
But, it's not just Gilead. The stock market has, on average, historically returned close to 8% per year. Those odds are certainly in your favor over the long run.
6. They're also a good reminder to reassess what you own
Lastly, a stock market correction is a good reminder for long-term investors to reassess their holdings.
As noted above, a dip in stocks isn't necessarily a bad thing as it could give you the opportunity to buy or add to high-quality companies; but it's important that you reassess your holdings to ensure that the thesis of your purchase remains intact. Ask yourself one simple question with each stock in your portfolio: Is the reason I bought this stock still valid today? If the answer is "yes," then no action is required, other than perhaps adding to your position. If your thesis is no longer intact, then it may be time to consider selling your position.
A stock market correction doesn't have to be scary as long as you keep the aforementioned six points in context.
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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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