How To Prepare For A Market Correction

With the major stock market indexes making one new all-time high after another so far in 2024, it's hard to believe, but corrections are a normal and healthy component of market cycles. Specifically, a market correction is defined as a drop in value of 10% to 20% and can affect individual stocks, ETFs, and major indexes like the benchmark S&P 500. Less frequently, a market correction paves the way for a flat-out bear market, which is represented by a dip of 20% or greater. (Review the differences between a stock market correction and a crash.)

Although corrections are a natural part of investing and can sometimes portend a further upward move, it might not feel so great when you're in the midst of one. A market correction can be caused by a wide variety of factors, including an overvalued market or sector, a slowing economy, or negative financial news. The latter includes unexpected "black swan" events.

These factors make it difficult, nigh impossible, to predict a market correction; and attempting to time the movements of the market is typically regarded as a fool's errand. That being said, it's highly recommended to have in place a more passive plan against correction(s). If you're wondering, the average correction is said to last approximately four months and the majority don't turn into bear markets, though some do. (Here's how to know when it's time to sell a stock.)

Diversify, diversify, diversify

To begin building your anti-correction strategy, evaluate your timeline for investing. Younger folks typically have a higher tolerance for risk. That's because if a correction (or worse) occurs, they'll still have plenty of time remaining for their investments to recover. On the other hand, an investor who's close to retirement age might take a more stable path with fixed-income securities, such as bonds and CDs, with only a small portion of their investment portfolio allocated to stocks. Later in life, some investors may prioritize preservation of capital over the potential for larger returns.

Next, you'll want to diversify your portfolio. Allocating some dollars to fixed income (stocks and bonds, for example) is a good start, but also consider things like cryptocurrency and precious metals, such as investing in gold or silver. (Check out our guide to buying gold bars from Costco.) Owning real estate is also a popular way to add variety. Doing so can take the form of buying a physical property, like a rental home, or investing in REITs.

A REIT, or real estate investment trust, is similar to an ETF, but made up of commercial real estate, residential properties like apartments, or a combination of these and other assets. REITs facilitate real estate investing without the fuss of owning and/or managing real estate properties directly. You can purchase shares of REITs through any regular brokerage account and it can also be a great way to generate passive income. (As for ETFs, here's what you need to know before investing.)

Use dollar-cost averaging to scoop up bargains

When preparing for a market correction, besides diversifying into other investment classes, also consider diversifying the equities (i.e., stocks and ETFs) that your portfolio holds. For instance, you might find you own all technology stocks, which have grown very pricey of late, defined by lofty price/earnings (P/E) ratios.

It's a fine line between rebalancing a portfolio and trying to time the market, which many experts recommend against. That said, there's nothing wrong with locking in some gains by selling a portion of expensive stocks that have gained in price to focus on so-called value stocks instead — those with lower P/E ratios. In a market correction, high-flying stocks which may have been market darlings also tend to decline in value more quickly.

Consider that in the 25-year period ending in 2022, the S&P 500 only had six years with negative returns. As such, a market correction isn't likely to be long-lasting, and paves the wave for healthy future gains. Still, after a long prosperous period, you'll want to reevaluate your risk tolerance and perhaps adjust for your age. As well, make sure all your proverbial eggs aren't in the same basket. In the end, the most important takeaway when it comes to market corrections is to continue to invest and use strategies like dollar-cost averaging to take advantage of market fluctuations that might otherwise be considered a negative.