Market corrections happen about once every 19 months – and we’re at 19. After the stock market’s fantastic growth in 2021, some believe a pullback (or even a correction) may actually be healthy for the markets. Such a pullback is not horribly painful, by historical standards, and smart investors can cushion such a fall.
Why is a market pullback or correction beneficial?
You can think of a mild pullback or correction as a type of blow-off value; it allows pressure to be released to help avoid a much larger breakdown, and it can help prevent a large bubble from forming.
Bubbles occur when stock prices get clearly out of line with the earnings potential of the underlying companies. We saw the consequence of that in the awful Technology crash of 2000-02 and Financial Crisis of 2008-09, when the markets collapsed, and some people lost half their wealth or more. Many companies didn’t survive.
Certainly, market corrections never feel healthy when they occur. People get fearful as the market declines, the media fan the flames by giving investors reason after reason to be afraid. It very well may be, but most modest pullbacks are not the beginning of the next crash.
Since 1950, the S&P 500 has experienced an intra-year peak-to-trough pullback of 5% or more in 67 out of 70 years. So roughly 93% of the time, a 5% correction has taken place from 1950- 2021. This could be considered normal market activity. The good news is many investors admit that a 5% pullback is manageably unpleasant, concerns expand when the market decline hits 10% or more.
When is the Next Correction Coming?
Here is what investors need to remember: the S&P 500 has nearly doubled in value since the market turmoil in March 2020. What has not happened since that time, however, is a selloff of at least 10% - that’s the definition of a market correction. In 29 of the past 50 years or 58% of the time the S&P 500 has experienced a 10% correction. Again, being that this happens more than 50% of the time, so this too should be considered normal. Since 1928, market corrections happen about once every 19 months.
How to Prepare for a Correction
Are you thinking: “I don’t think I can stomach a loss of 10%? Then that’s where the wisdom of diversification becomes apparent. Remember that the data above represent the historical performance of the S&P 500. A well-designed financial plan and portfolio can help ensure you have the proper asset allocation: a proper mix of Stocks (Small, Medium, Large, International, etc.), Bonds (Gov, Corp, Preferred, etc.), possibly some alternative investments, and Cash. Your portfolio should be designed to represent your tolerance for risk.
So having proper diversification can keep you in the “manageably unpleasant” range. If not, you may need to reevaluate your risk tolerance to ensure you are not exposing your nest egg to a larger loss than you can endure. Although the recent market pullback will produce lots of fear, we’ve been here before. If you know what you own and why, then you should rest easy.
-Paul R. Rossi, CFA