Market corrections can be nerve-wracking. Seeing anything you own depreciate in value is never a comfortable feeling.
Beyond a depressed stock portfolio or home value, a market correction can impact the overall economy, cause a higher unemployment number, and influence interest rates. Despite the fear a market correction can bring, a market correction is unavoidable.
However, there is always a silver lining, and a stock market correction, or housing market correction, can also provide tremendous upside potential. What should you do during a market correction? We’ll cover that in greater detail below!
What Is a Market Correction
What is a market correction? Simply put, a market correction is a change in the overall direction, or price, of the market. Market corrections exist in every market. This term is commonly used when discussing the stock market, housing market, or money market.
To better understand a market correction, consider the following example:
Imagine if the U.S. stock market had gone up each year by 12% for the trailing 5-years. All in all, this would be considered a healthy return. But as the saying goes, what goes up, must come down.
It’s wrong to assume the stock market will just continuously rise without ever pulling back for a bit. That pullback, at a large scale, is the market correction.
Why Do Markets Correct
Understanding why a market corrects can be incredibly complicated. There are an endless amount of factors that drive a market to new highs, and there are also an endless amount of reasons that can cause the price of the market to do a reversal.
However, the number one rule in economics plays a major role, as do two very powerful emotions. The basic economic rule is supply and demand, and the overarching emotions are fear and greed.
When people feel like times are too good to be true, and a market correction is on the horizon, their fear kicks in and they begin to sell off their ownership. When times are in a slump, people let optimism kick in, and they purchase the underlying assets in the market in hopes of appreciation.
This dynamic influences the supply and demand of the overall market, which ultimately controls the price changes.
A market correction is just part of reality, it doesn’t matter if you’re talking about the U.S. stock market, real estate market, currency market, or bond markets. Knowing this, what should you do during a market correction?
Having a playbook that you develop proactively will be a great way to to start.
Have Cash Reserves
First and foremost, having cash reserves can help you successfully navigate a market correction. Market corrections could bring an increase in unemployment numbers.
Having cash reserves can give you financial breathing room. A general rule of thumb would be to have 3-6 months of living expenses saved up.
Additionally, if you never needed the breathing room, cash reserves can help you make good investments, which we’ll cover in greater detail below.
Do Not Let Emotions Overpower Your Mind
Remember, fear and greed are two emotions that tend to cloud vision. Do all you can to manage these emotions and think logically about your financial situation and future.
Monitor Interest Rates
It’s not uncommon for lenders to reduce the interest rate on borrowed money during a market correction or economic downturn. When a market corrects, you may find yourself saving a lot of money per month if you are able to refinance your debt at a lower interest rate.
For example, if you are paying a 4.25% interest rate on your mortgage and the current rate is 3.25%, refinancing can save you thousands of dollars over the lifetime of your loan!
Capitalize on the Lower Prices
As mentioned above, cash reserves provide you with financial breathing room. Additionally, cash reserves allow you to capitalize on the lower prices in the market.
For example, if the housing market is corrected by 10%, you can buy a house ‘on sale’ and save a great deal of money. If the U.S. stock market corrects itself, you can buy stocks at a lower price.
When the market rebounds, you are positioned to make a healthy profit!
Diversify Your Portfolio
In addition to the above points, one of the main things you should consider doing to successfully navigate a market correction is to make sure your portfolio is diversified. Diversification simply means you are not over-invested in any specific asset class or any specific equity.
Spreading your money out across various asset classes, and across various equities or investments, will reduce your portfolio’s overall risk exposure.
Know Where to Move Your Money
During a market correction, various investments perform better than others. For example, consumer staples are needed regardless of economic conditions.
Investing in the best-of-breed consumer staple companies is a common approach to take during a market correction. People will always need toilet paper, toothpaste, and healthcare products!
Are You Prepared?
The above steps and considerations are important to help you prepare for a market correction, however, it can be intimidating preparing for a market correction on your own. Luckily, you don’t have to.
Financial advisors not only exist to help you realize a greater rate of return on your investments, but they will also help you protect your portfolio and ensure you are being financially responsible with your decisions. A good financial advisor will help you build enough cash reserves, diversify your investments, and can also help you manage your emotions if/when the market moves in an unfavorable direction.
Working with a financial advisor will help you navigate both good and bad markets, and ensure you are well situated to handle any market correction.