How to Manage a Market Downturn
KEY TERMS AND DEFINITIONS
Market Correction: as an investing term, a correction is typically defined as a decline of 10% - 20% in the price of a security, asset, or a financial market from its most recent peak value.
Bear Market: a prolonged decline of 20% or more in the price of a security, asset, or a financial market from its most recent peak value.
Stock Market Crash: descriptions of this term vary, but it commonly applies to an abrupt decline in the stock market index over a single or several days. In the U.S., stock market “crashes” have occurred in 1929, 1987, 1999-2000, 2008, and 2020.
Bull Market: a prolonged rise of 20% or more in the price of a security, asset, or a financial market from its most recent low value.
Behavioral Finance: an area of study focused on how psychological influences can affect market outcomes. One of the key aspects of behavioral finance studies is the influence of psychological biases.
UNDERSTANDING MARKET CORRECTIONS
Experiencing a decline in your portfolio value, often related to a market trend such as a correction or bear market, is disturbing. However, it is important at these times to understand your biases, take historical data into account, and stay focused on a long-term investment strategy.
Market corrections are a natural part of market behavior.1 History shows that a 10% correction occurs roughly every two years, making them frequent and normal events.2 While corrections may feel worrisome, they often just reflect temporary adjustments to changing economic conditions. Unlike crashes or prolonged bear markets, corrections are usually short-lived and often recover within months.2
Recognizing that corrections are a regular part of a healthy financial ecosystem can reduce the temptation to make hasty, emotional decisions and instead foster confidence in a long-term approach.
HISTORICAL PATTERNS: HOW QUICKLY DO MARKETS RECOVER FROM CORRECTIONS?
History reveals that market corrections are usually short-term setbacks. Markets often recover from a 5-10% dip within about three months, and corrections of 10-20% typically rebound in around eight months.3 While no recovery is guaranteed, these historical patterns are important, reminding investors that downturns do not usually have lasting effects on long-term wealth.
For example, even market dips in recent decades have eventually been followed by rebounds and growth periods.3 Reflecting on these patterns can reinforce the importance of staying invested through volatility, allowing for potential recovery and opportunity for continued portfolio growth.
Example – August 2024: The S&P 500 index fell just over 6% in the first three trading sessions of August and was down 8.5% from its July high at that point. Market news included statements such as: “Don’t panic, but more losses ahead”, “Global asset meltdown”, “Prepare for a new high-volatility market”, and “Volatility rips through Wall Street”. However, similar to many previous historical examples, the S&P 500 rallied by 9% to end August with a gain of 2%.
PSYCHOLOGICAL FACTORS: WHY INVESTORS OFTEN PANIC
During downturns, many investors are prone to panic, driven by psychological factors and biases. Understanding these factors may help you recognize their influence and help you stick to your long-term strategy. The August 2024 example cited above showcased examples of each psychological factor listed below. Note that these factors can lead to either overly pessimistic or overly optimistic viewpoints.
Herd mentality is the tendency of the people in a group to think and behave in ways that conform with others in the group rather than as individuals. In financial matters, this tendency is often exacerbated by financial news feeds, social media and forums such as Reddit, Motley Fool, and others.
A common bias is loss aversion—the tendency to feel losses more intensely than gains. This can lead to impulsive moves, such as selling off investments to avoid further declines, even if doing so undermines a long-term strategy.4
Another bias is recency bias, where recent events such as market corrections feel more significant and enduring than they likely are. This bias can cause investors to make assumptions based on recent performance only and are no longer looking at the full picture.5
THE IMPORTANCE OF ESTABLISHING A LONG-TERM INVESTMENT STRATEGY
Long-term investment strategies are designed to manage various market cycles, including corrections, and take advantage of the long-term growth trends of financial markets. A well-structured investment plan should balance risks and rewards over time and will typically be based on a diversified portfolio of assets to weather market volatility.
By diversifying investments across various asset classes—such as stocks, bonds, cash and real estate—you reduce the impact of any single market event. This diversity helps smooth out portfolio performance, as different types of assets often react differently to economic shifts.
In addition to diversification, regular rebalancing can help maintain your desired risk level. Rebalancing involves adjusting your portfolio back to its target asset allocations, ensuring it remains aligned with your strategic goals.
While short-term dips and corrections are inevitable, markets have shown resilience over time. By maintaining a years-long perspective, investors can avoid the stress of short-term market movements and focus on achieving their larger financial objectives.
HANDLING MARKET CORRECTIONS
The most-important step to being prepared for such market events is to have a well-structured financial plan including a strategic investment strategy, as noted in the previous section. You will lean on this strategy during times of market volatility, to avoid being tempted to veer off course by reacting to short-term market fluctuations.
By resisting the impulse to react during corrections, you can avoid reactionary decisions that might disrupt your portfolio’s potential for growth, as sudden moves may lead to missed opportunities and timing errors.
Sticking to your plan requires patience and determination, but it is a cornerstone of successful long-term investing.
BOTTOM LINE
Patience and consistency are more impactful to the success of a strategic investment plan than reacting to short-term volatility, and the results often speak for themselves: disciplined, long-term investing is a proven path to building wealth.
Market corrections, while challenging, are an opportunity to strengthen your commitment to long-term investing. By understanding corrections as part of the natural market cycle and staying focused on your broader goals, you can sustain a resilient portfolio that is well-equipped to meet your financial objectives.
Collaborating with a financial advisor can help you build a sound financial plan and make informed decisions to help navigate market fluctuations with confidence.
REFERENCES
The articles below were referenced in preparing this information and are excellent resources to better understand this topic.
https://www.kiplinger.com/investing/historical-stock-market-patterns-for-investors-to-know
https://www.invesco.com/us/en/insights/investors-stock-market-corrections.html
https://www.investopedia.com/recency-availability-bias-5206686
https://www.morganstanley.com/cs/pdf/619598-3174306-MSVA-Behavioral-Guide-r7.pdf
This content was developed from sources believed to be providing accurate information. The information provided is not intended as tax or legal advice, and readers are encouraged to seek advice from their own tax or legal counsel. Neither the information presented, nor any opinion expressed, constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material is based in part on an article posted by Advisor Websites and was edited by Eustace Advisors to provide information on a topic that may be of interest.