Updated 2/28/22
In the same way a car’s engine can overheat, the stock market can overheat after periods of sustained and, more often than not, rapid growth. At the peak of these growth periods, stocks prices may have even increased faster than their actual underlying value. In these instances, the stock market typically enters a market correction. To put it simply, a market correction is a temporary resetting of market prices. Market corrections typically involve the market falling at least 10%, but it can even fall as much as 20%. While no investor wants to see their account down 10%, market corrections help to ensure our stock market remains at a healthy valuation.
While certain asset classes and sectors of the economy can go through isolated corrections, a market correction tends to affect all areas of the market at once. Once the market has seen a broad pullback amongst the sectors of the economy, stocks will once again continue their growth at their newfound prices and healthier valuations.
Unfortunately, there is no crystal ball for predicting market corrections. However, we can look back in history to create realistic expectations. Since 1942, the S&P 500 historically has had a 10% or worse correction every 16 months on average. For perspective, this current pullback is the first 10% or greater pullback in the market since the crash that began in February 2020, meaning that, if history is to be our guide, we had been long overdue for a correction.
Finally, the burning question on everyone’s mind: what should I do? Whether you are a 401(k) participant or an individual investor, the best course of action is to stay the course during market corrections. In fact, 401(k) participants in particular are uniquely capable of taking advantage of these drawdowns. 401(k) contributions are made through a process called dollar-cost averaging, which simply means investing a consistent dollar amount on a scheduled basis. Dollar-cost averaging helps investors to avoid the two dangerous emotions of investing: greed and fear. Through dollar-cost averaging, 401(k) participants can consistently buy shares of their investments at the new, cheaper prices set during a correction. Once these shares increase in value during the correction’s recovery, you will own even more of these shares, taking advantage of the eventual rebound.
While it is much easier said than done to stay the course during a correction, it is important to remember that we are long-term investors for retirement. Our best advice is to remain calm and stay informed. While we cannot know for certain what size this pullback will be, we know that history shows us that corrections are a natural, healthy, and relatively frequent occurrence in our markets.
