Reblog: How to Tell a Stock Market Correction From a Crash
News that the Dow Jones Industrial Average is down several hundred points sends shivers down the spine of even the most weathered investor. Such drops, while infrequent, can be scary because it’s impossible to predict how severe or long-lasting losses will be. And even if you trust the market will eventually rebound (as it always has), it’s hard to watch the value of your investments shrink before your eyes.
In the immediate term, people will argue about what to call it — a crash? A correction? Leave the vernacular to others, and instead understand what’s causing the market to fall. This knowledge may not bring your money back right away, but it could help you prepare for the market’s next move up or take advantage of lower stock prices in the meantime.
Defining a drop in the stock market
Like the tale of Eskimos having dozens of words for snow, investors have many words for a decline in the stock market. These words distinguish the length and severity of the fall, though their definitions are not etched in stone.
- A dip is any brief downturn from a sustained longer-term uptrend. For example, the market may go up 5%, linger, and come down 2% over a few days or weeks.
- A crash is a sudden and very sharp drop in stock prices, often on a single day or week. Sometimes a market crash foretells a period of economic malaise, such as the 1929 crash when the market lost 48% in less than two months, kicking off the Great Depression. But that’s not always the case. In October 1987 stocks plunged 23% in a single day, the worst decline ever, before roaring back over the next year. Crashes are rare, but they usually occur after a long-term uptrend in the market.
- A correction is often defined as a 10% drop in the market from recent highs.
- A bear market is a long, sustained decline in the stock market. Once losses surpass 20% from the market’s most recent high, it’s considered to be a bear market.
Investors use these terms to describe the market as a whole, but individual stocks experience the same phenomena, and usually with much more volatility. Whereas it’s a big deal if the market declines 10%, it’s not unusual to see a stock plummet 20% or more during that period.
Why the stock market crashes?
At the most basic level, the market declines because investors are more motivated to sell than to buy. That’s simple supply and demand, but it doesn’t explain why investors are selling.
“The market moves for many reasons, including because the economy is actually weakening, or based on investors’ perceptions or emotions, such as the fear of loss.”
Investors are a forward-looking bunch. They’re trying to determine whether their investments will appreciate in value. Investors watch for signs, including news, rumors and anything in between, of how the market will move. It moves for many reasons, including because the economy is actually weakening, or based on investors’ perceptions or emotions, such as the fear of loss, for example.
While the reasons for a one-day drop may vary, a longer-term decline is usually caused by one or several of the following reasons:
- A slowing or shrinking economy: This is a solid, “fundamental” reason for the market to decline. If the economy is slowing or entering a recession, or investors are expecting it to slow, companies will earn less, so investors bid down their stocks.
- Lack of “animal spirits”: This old phrase refers to the surges of investor emotion and risk-taking during a bull market. As they see the chance for profits, people jump into the market, pushing stock prices up. When those animal spirits dry up? Watch out below!
- Fear: In the stock market, the opposite of greed is fear. (And nothing is quite so good at stoking investors’ fears as a 24-hour news cycle that blasts how much the markets are going down.) If investors think the market is going to fall, they’ll quit buying stocks, and sellers will have to lower their prices to find takers.
- Outside (and outsize) events: This miscellaneous category consists of everything else that might spook the market: wars, attacks, oil-supply shocks and other events that aren’t purely economic.
These reasons often work together. For example, as the economy overheats, some investors see a slowdown in the future and want to sell before a stampede of investors flees the market. So they sell, pushing stocks lower and dampening animal spirits. If the move down persists long enough, it may make investors fearful, sending stocks still lower.
At times like this, it can be great to have someone by your side to steady your nerves, and that’s one thing that the best financial advisors do.
How long will the sell-off last?
That’s a billion-dollar question. If you knew that, you could time the market and become rich. Still, there are some guideposts for how long crashes, corrections and bear markets last. (We’ll skip dips for now; there are just way too many of them.)
- In the last four corrections since the 2008-09 global financial crisis, the average decline was 15.3% over three and a half months.
- Bear markets tend to be longer still. In the three bear markets since 1987, the average decline has been 46.5% over 1.4 years.
In contrast, the last three bull markets have lasted nearly nine years on average. Downturns tend to be short-lived, especially relative to uptrends.
What happens to your portfolio in a market crash?
The Standard & Poor’s 500 index is the usual benchmark investors reference when they talk about “the market,” as it comprises the largest publicly traded American companies. But unless you’re invested exclusively in an S&P 500 index fund, your actual returns will differ from the market’s because you don’t own the same stocks in the same proportions as the index.
“Unless you’re invested exclusively in an S&P 500 index fund, your actual returns will differ from the market’s.”
Gauging how you’ll fare in a market crash depends on the composition of your portfolio. The performance of individual stocks tends to be more volatile than that of the market. If the S&P 500 were to drop 10%, individual stocks in your portfolio could decline 5% or 15% or 30%. Some might even go up.
Finally, it’s important to understand that if a stock’s price declines by 30%, you’ll be waiting for an increase of more than 30% to recoup your losses. For example, imagine a $100 stock that declines 30%, to $70. That stock has to rise nearly 43% to get back to $100.
How can you prepare for a crash?
Knowing what’s happening when stocks are dropping is the first step in protecting yourself from the emotion and panic that accompany a financial loss.
The original post is written by James Royal, appears on nerdwallet.com and is available here.