Scary Finances: What a Market Correction Means

While we have enjoyed steady gains in the equity markets, corrections do happen. When the next correction occurs we offer the following thoughts for investors to keep in mind.

A stock market correction is often announced with attention-grabbing headlines. The effect can be scary and overwhelming to any investor. It’s hard to stay calm and not panic when bright red numbers and flashy headlines tempt you to take immediate action. Let’s discuss what a correction in the market means and how it may impact you.

How Is the Market Monitored?

The Dow Jones Industrial Average (DJIA), is a stock index that monitors the value of thirty publicly traded U.S. companies. When the DJIA decreases, it is referred to as the market dropping. When the DJIA decreases so significantly that it has lasting effects on the economy, it is referred to as a crash. The market sometimes falls because investors have become cautious about putting their money in one or more companies that the DJIA represents. Factors that can attribute to this include natural disasters, oil prices increasing, economic issues in foreign countries or a downturn in the U.S. economy.

What Are the Impacts of a Market Correction?

Day to day, market values fluctuate in a fairly narrow band, approximately +/- 2-3%. This is normal market volatility. When the market drops slightly, investors are likely to buy stock believing that it will increase when the market recovers. This will earn them a profit. But a more significant fall can decrease the value of the investor’s assets. This can occur for several reasons. The market has become overvalued and the broad consensus of investors is that prices need to adjust, or “correct.” Thus the name.

In some cases, there is broad consensus that there is deep trouble in the financial sector. That can lead to the type of severe drawdown we experienced in 2008. It turned out that the financial consequences were less severe than investors feared and the actions taken by the Federal Reserve prevented the situation from becoming worse. Investors who resisted the urge to sell, profited, in some cases handsomely. The old notion that “panic kills” is very apt in this situation. Investors who liquidated holdings at below fair value locked in losses that can never be recovered.

The status of the stock market is one, but certainly not the only indicator of the overall state of the U.S. economy. If investors and consumers are concerned about their personal financial situation, they may begin spending less money, resulting in a declining economy. However, the linkage between the stock market and the overall economy is not perfect, and it is subject to lags. A market correction is by no means an indication of a recession.

What Should I Do If the Market Drops?

business woman remaining calmStay calm and focus on the long-term health of your finances. We take great care to build portfolios to be resilient. Properly diversified portfolios are established commensurate with your level of risk and your long-term goals. While there are no guarantees of future risk and return, there are several appropriate responses to a market correction:

  • Rebalance your portfolio. Monitor your portfolio and assess whether your allocations need to be rebalanced to meet your targets.
  • Employ tax loss harvesting. Identify losses in your portfolio, and use them to help lower your end-of-year tax bill. You can offset up to $3,000 of income yearly with tax losses, once gains and losses are netted against each other. There are limitations and IRS regulations surrounding tax loss harvesting, so be sure to work closely with your tax advisor.

It is also an excellent idea to regularly meet with your advisor to review your financial plan and your progress against your goals. It is also wise to inform your advisor of any changes, such as a different time horizon for your major life events.

Generally, the best thing to do during a correction is to remember long-term investment plans, factoring in short-term market volatility. Don’t let emotional responses drive bad decisions. Talk to your advisor about any concerns you may have before taking action on your own. .

Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.

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