What is a stock market correction? How to make sense of sudden drops in the market

• A stock market correction is a brief dip in the value of individual stocks or the overall market.
• Market corrections occur regularly and can help prevent artificially inflated stock prices.
• They are nothing to worry about in most cases, as long as you're investing long-term.

There's nothing quite like the rush of watching your investments gain value. The same could be said about the moment of panic when you see them start to take a tumble.

However, it's common to see plenty of ups and downs in the market.  Many of these dips are stock market corrections, and understanding what that means can help you better manage your portfolio and protect your wealth. 

What is a stock market correction?

A stock market correction is a brief dip of 10% to 20% in the market or individual stock that occurs to correct artificially inflated stock prices and unsustainable growth. They typically last a few months, although some last only a few days.

A stock market correction can occur for a number of reasons. Many investors chase market trends, so if people are buying a stock because they believe it will rise in value, others are likely to follow suit. This causes the price of that stock to rise. As this happens, some investors who hold that stock may begin to sell in order to turn a profit while the price is high, as will others, causing the stock price to dip temporarily.

This can happen on a larger scale as confidence in the market waxes and wanes. Good news can artificially inflate stock prices, and sometimes the market reaches a point when demand for stocks goes down, forcing investors who want to sell to lower prices.

What are the effects of a market correction?

In these situations, the market dips to correct itself to avoid a market crash. This typically occurs during an overall period of growth. 

Historically speaking, most market corrections have not gone beyond a 20% decline, and they often resulted in a bounce back to normalcy or even a bull market — that is, a period of significant growth.

However, it is possible for a market correction to transform into more dire conditions. If a decline surpasses 20% and lasts for a sustained period of time, it transforms into what's known as a bear market. These periods of market decline are often accompanied by economic stagnation and increasing rates of unemployment. Sometimes they can lead to a recession.

While this describes the effect on the market as a whole, it's important to note that not all stocks react to a correction equally. High-growth and more volatile stocks tend to be the most reactive, while non-cyclical stocks, such as defensive stocks will be less impacted.

Why do market corrections matter?

Market corrections can impact the performance of your stocks so it's always a good idea to know when it's happening.

In general, market corrections impact most long-term investors minimally, as long as it doesn't evolve into a recession. A brief dip isn't troubling as long as your portfolio continues on a general upward trend, so time will likely be on your side. 

This is even more true if you've diversified your portfolio by holding stocks in a wide range of sectors. This includes non-cyclical stocks, also known as defensive stocks, which tend to perform well even under slowed market conditions.

But for short-term investors such as day traders and others attempting to "time the market," market corrections can present both significant opportunities and obstacles. 

On the one hand, a market correction can be a good time to purchase valuable stocks at discounted prices. On the other hand, this is quite risky, as stocks could continue to dip further. Being forced to sell during a dip can be an expensive mistake.

Some investors will attempt to predict market corrections using market analysis and by comparing market indexes to purchase at a low. But it's difficult to know for sure when it will happen and what the end result will be. For this reason, it's generally a better idea to keep your portfolio diversified and rely on long-term growth rather than short-term gains. 

As you near retirement age, you can rebalance your portfolio regularly and shift your investments toward more stable assets such as bonds. This will protect your portfolio from losing value at a point when you don't have enough time left for it to recover.

The bottom line

Stock market corrections can be scary, but they're a natural part of how the market behaves. If there's one rule to follow in investing, it's not to make impulsive decisions based when the market declines.

Knowing what a stock market correction is and how it works can help you better understand the nature of your investments so you can manage them more efficiently.

Some may use corrections in an attempt to time the market, but you're more likely to benefit by simply using this knowledge to remain steadfast when your portfolio takes a hit rather than selling at a loss. When it comes to the stock market, having patience and ensuring you have a diverse portfolio during dips is the best way to go.