What is a “market correction”?

Unlike some projections of future values, investment markets do not proceed forward in a straight line, but rather feature fluctuations on every time scale.  Fluctuations are due to the constant reassessment of investors about the future value of each investment based on the constant flow of new information.  These fluctuations are a normal and healthy part of the most complex economic structure in existence – the investment market.

As you may recall from the 200 year historical chart of investment asset class performance by Prof. Jeremy Siegel, which I often use to provide context, the U.S. stock market has compounded at a rate of close to 7% after inflation.  However, at any given time the actual market value is usually above or below its average.  There have been a few times like the technology boom of the late 1990s when the market price is well above average and a few times like the 2008 financial crisis when it is way below average.  What many investors do not realize is that there are “corrections” of 10% to 15% that occur on average EVERY year.  These too are a normal part of the inexorable upward march of equity markets and must be embraced as an organic part of the process of long term gains.

At present, it has been about two years since the last 10-15% correction, so one might say we are overdue.  There is no way to know when or for what reasons such a fluctuation will occur but it is fair to say they will continue forever.  This month may mark one of these corrections, we’ll have to wait and see.  The term “correction” is suitable in some ways because it denotes a modest change to return prices to their longer term trend line.  It is unsuitable in other ways because it might indicate there is something wrong with the current price level, which is not necessarily a proper perspective. A correction may occur when prices are at any level and for no single apparent reason.  A correction may occur just because things have been stable for quite a while and investors have become complacent.

As long term investors we benefit from such corrections because we do not react to them by selling when prices are low and because every such time is an opportunity for our professional fund managers to adjust their portfolio to take advantage of some new and lower prices.  For example, last year (2013) saw very large gains in the world stock market and your fund managers sold some of their holdings that had reached their target prices.  In some cases they did not find attractive new investments and so held onto cash until new bargains could be found.  When a correction occurs and prices fall, new bargains may emerge.

Let’s hope that if a correction is what we are seeing, that it does not end too quickly and so allows our fund managers to take advantage of lower prices.