One day in a beautiful summer afternoon, your regular physician asked you to come in for a further discussion on the results of your regular checkup. This has never happened before and you can literally feel your heart beginning to sink as your physician told you that they’ve detected a tumor inside your lungs. Before the physician can proceed any further, you’ve already begun sobbing at the cruel injustice that fate has dealt you and it wasn’t after you’ve showered your physician with stories about your pregnant spouse and how happy you were during the first ultrasound that your physician finally tells you that the tumor is benign. Well, that was much ado about nothing, wasn’t it?
The same thing applies to the financial market. The skills you’ve acquired from whatever trading courses you’ve completed and how many trading books you have read won’t be of much use if you can’t contextualize what each move in the market means. Whenever you see headlines with sensational word like market plunges or nosedives or other similar words, it might be a good idea to first ask why instead of how much. Just like how tumor can be either benign or malignant, a particular negative movement in the market can mean a number of different things, two of which is market correction and the more pervasive market crash.
Correction is the tool for creating better from worse
There is no absolute definition to what constitutes a market correction but it is generally accepted that a correction refers to a negative movement of at least 10% in the market, a specific index or even an individual stock. The key difference between a correction and a crash is the point at which it is measured. A correction refers to the 10% of its most recent high while a crash is irrespective of its most recent high. The reason why it is called a correction is because it usually happens to adjust for an overvaluation and during the middle of a general uptrend in the market. Some of the key indicators to know when it comes to a market correction are:
- They happen particularly often and for a relatively short time. Unlike crashes, which happens rarely but always violently and usually a precursor to a general recession, corrections are more regarded as part of a natural cycle of the market and at times, welcomed by experienced investors.
- They are both inevitable and unpredictable. The general wisdom is that it is almost always impossible trying to figure out if a particular movement is a crash or a correction. This is wrong, it is possible to figure out whether there’s an economic bubble or not and just how bad it’s going to be when it would eventually burst. In the 2015 film The Big Short, the character Michael Burry, played by Christian Bale in the film, predicted that the United States housing bubble is going to burst at some point, allowing himself to massively profit in 2008 by betting against it and the economist Robert Shiller won a Noble prize for predicting the dotcom bubble burst of the early 21st century.
- They are used for reassessing your portfolio and gather on cheap stocks. Unlike in a crash that would usually trigger a recession or a bear market, correction is the perfect time to invest on some of the higher-valued stocks while prices are down because you know it’s going to bounce back relatively quickly.
If avoiding a crash is impossible, brace for it
As with correction, there is no absolute definition for a market crash but it is generally defined as a double-digit dip drop in a stock index in a relatively short amount of time, usually over the course of a few days due to the collapse of a speculative bubble. While the crash itself isn’t bad, it could lead to what is termed as panic selling, in which a mass withdrawal of investments occur due to pervasive fear, which acts as a self-fulfilling prophecy of some sort, making the matter even worse and usually lead to a general recession. As a crash is usually triggered by what the general market does, it is almost impossible for a single investor to avoid the impact of a crash, but it is possible to prepare for one by looking at the indicators, some of which are:
- They’re relatively rare but the impact is almost always extensive. The 2008 financial crisis lead to the demise of one of the biggest investment bank at the time, Lehman Brothers and pushed the US government to enact one of the biggest regulation changes since the Great Depression of the 20s with the Dodd-Frank act. The Japanese housing bubble burst of the early 90s ended the golden era of Japanese automotive industry and 10 years of economic stagnation commonly known as the Lost Decade.
- They arrive at the end of a bull market or a speculative bubble. All of the crash examples listed above happens when an economic bubble burst and if you stretch back all the way to the 18th century for the South Sea Bubble, where the titular company took advantage of Britain’s colonial expansion at the time to spread excessively exaggerated claims on opportunities within the New World which at one time raised the company’s stock price to £1,000, ten times its original price of £100 before falling back again.
- Each crash lead to tighter regulations. Probably the only silver lining to be gathered from a crash is this; they almost always lead to stricter financial regulations and systematic improvements, enacted to keep the same crash from happening again. While there has been notable crashes in the last few years, the impact from these cases have been mostly isolated, like the Chinese stock market bubble of 2015 that prompted a response from the Chinese government that same year which helped mitigate the effects
Correction and crash are two completely different things but they have one thing in common, you should stay calm in response to these two movements. Correction is only temporary, so holding your position is advisable while with a crash, engaging in a panic selling will only exacerbate the problem and selling your stocks at a low price isn’t exactly a good idea in the first place. The only thing you can do when it comes to crashes is to prepare for it, either by diversifying your portfolio or selling your stocks before a crash happens.