As has been seen over the last few years, all investments can fluctuate in value so you could get back less than you invest. This is something which should always be explained from the outset to anyone wishing to invest. Global stock markets have been volatile since the beginning of the year, with a sea of red across most major market indexes. January experienced the worst weekly performance for global stocks since October 2020. Continued anxiety surrounding high levels of inflation and the threat of interest rate increases have made a lot of investors feel very uneasy. The markets in the US have borne the brunt of this the most, with technology shares being hit particularly hard. The tech-heavy NASDAQ index, which is home to some of the biggest names such as Apple, Amazon and Microsoft, fell into ‘Market Correction’ territory this month which is the 66th correction since the index was created in 1971. While these market decreases certainly aren’t favourable, it is important for investors to hold their nerve during these times of uncertainty. Over the longer term it can mean the difference between investment success and investment failure. Taking this into account, it is important to take a closer look at market corrections i.e.. What they are, why they happen and how investors should react.
What is a stock market correction?
- When the level of an index falls by 10% or more from its most recent peak, this is what is known as a market correction
- Market corrections appear in varying forms. In some instances, decreases are spread evenly across global stock markets. In other instances, sell-offs are more focused on a particular country or sector. The reasons behind the why the correction has occurred in the first place, is usually where the impact is felt the most.
What causes a market correction?
- There isn’t always a specific reason for sudden drops in the markets. However, corrections typically stem from a reaction to an unexpected economic event that causes markets to change quickly. This is why it is often impossible to predict the direction the markets will take in the short-term. Valuations can also indicate that a market correction may not be far away. In periods of strong and sustained growth, such as we have seen over recent years, certain investments, sectors or markets can become overvalued. This can cause investors to cash in on profits when the outlook for the economy and the companies they invest in start to look less encouraging. Ultimately, a market correction will occur when the rate at which investors withdraw from the market is greater than the level at which they are investing. Below are two examples of the types of behaviours which can cause a situation such as this to happen –
- Rising inflation is not usually good news for the stock market and investors. This is due to the increased costs incurred for companies which essentially erodes the bottom line. It also makes it more difficult to obtain a ‘real’ return as it’s tricky to outpace the rate of inflation.
- If interest rates increase, this can often cause uncertainty across the markets. Higher interest rates make the cost of borrowing money and servicing existing debt more expensive. This can cause issues for companies who need to borrow money to fund future growth opportunities or those who already have a substantial amount of debt.
How do rising interest rates affect the stock market?
Political events such as general elections, referendums and budget announcements can all cause investors to object to investing within certain countries. For example, the UK has suffered with investors being uncertain as to how companies would prosper post-Brexit. In addition to this already challenging situation, the Covid-19 pandemic has had an immense impact on the marketplace. When global lockdowns were announced back in March 2020, stock markets around the world fell significantly as investors feared how companies would be able to cope under such extreme conditions.
How investors should react
In events such as the ones mentioned previously, we would advise investors not to panic and that sometimes doing nothing is for the best. Selling your investments on the worst days in the market could mean you miss out on the best days. Short and sharp falls in the value of your investments is, undoubtedly, unfavourable however, it is important to resist the urge to make any reckless and irrational decisions based on emotion. If you are a novice investor, you will probably not have experienced a market correction before which could prove somewhat nerve-wracking. However, once you’ve seen your investments drop in value and then hopefully recover, future market corrections can become less stressful. Investing for the long term i.e. at least 5- 10 years and remaining calm during market ups and downs provides the best opportunity for investment success although, nothing can be guaranteed when investing. There is always a chance the value of your investments may not recover and you could get back less than what you initially invested.
Topping up your investments after a recent market correction could help lower the average price paid for your investments over time however, it is important to assess the risks with this approach. It is difficult to know where ‘the bottom’ of a market correction is and prices could continue to fall back further into a ‘Bear Market’ which is a situation where prices fall by 20% or more from the recent peak. As always, any investments bought should be based on your investment objectives, attitude to risk and there should be a specific need for that investment in your portfolio. Diversification of funds is key for facilitating minimum disruption to your investments from any market decreases which occur. Holding a mix of investment types such as shares, bonds and commodities can help protect your portfolio from the worst of market falls.
Please feel free to contact us at any time to discuss any queries or concerns which you may have.