Q: People keep warning the stock market might suffer a correction. What is a correction, why do they happen and what should investors do to prepare?
A: Corrections are the equivalent of physical exams for investors. They're not fun, but corrections are part of a healthy stock market and part of life.
The unofficial definition of a stock market correction is a decline of 10% or more from a recent high. Corrections tend to occur following a sharp run-up in stock values, but can occur any time, with little or no warning.
Corrections often happen so quickly that by the time investors start thinking about bailing out of stocks, they're over. The sudden nature of corrections explains the old saw on Wall Street: "Stocks take an escalator up, but an elevator down."
There are countless reasons why a correction might occur. Sometimes corrections are triggered by an external event, such as a sharp rise in energy prices, and the subsequent fear that consumers and businesses might be hurt. Sometimes they're triggered by government actions, such as increased taxes or the Federal Reserve's changes to short-term interest rates. Corrections can also start when economic data on job creation, inflation or manufacturing point to trouble.
And there are times when corrections begin for no apparent reason. From time to time, after a sharp run-up, investors decide to lock in profits by selling stock. This selling can beget more selling, and before long, you have a correction.
The most dangerous thing about corrections is the fear they plant in investors' minds. After stocks fall 10%, there's the fear that more declines might be coming. Many investors are tempted to sell into a correction for fear a full-fledged bear market (a 20% drop) is on the way. This panic selling turns out to be a big mistake if the correction is short-lived.
The best way to prepare for a correction is deciding, before a correction starts, what you would do if there is a correction. If you react to a correction when it happens, you'll find your judgment distorted by fear and that could lead you to make a poor decision.
Here's a way to think about it. If you own individual stocks, it's a good rule of thumb to be prepared to sell if they fall more than 10% from your purchase point. Individual stocks tend to be volatile, and you don't want to suffer a massive loss that will be nearly impossible to recover from.
If you own a diversified basket of stocks such as an exchange-traded fund (ETF), you can afford to be less jumpy. You might decide that if stocks go into a correction, you might actually invest more. That way, you can add shares at lower prices. Investing more during a correction means your portfolio will get back to even faster.
If you decide you can't bear to take a 10% loss, maybe it's time to re-examine your portfolio. Corrections are part of stock investing. If you don't want to endure a correction, you might consider shifting out of stocks and into more stable investments before the next correction shows up.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at firstname.lastname@example.org. Click here to see previous Ask Matt columns. Follow Matt on Twitter at: twitter.com/mattkrantz
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