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What Is A Stock Market Correction (And Why It Matters)

Posted By Jim On 11/28/2007 @ 7:41 am In Investing | 3 Comments

A stock market correction is when a major index (or the market in general) falls 10% in a relatively short period of time. In our case, as a result of yesterday’s decline, the Dow has fallen about 10% from its highs in October and so many pundits are calling it a stock market correction. On Monday, after that big two hundred point plus drop, we were solidly into market correction. On Tuesday, we snapped out of it as Citi received some overseas investment from Abu Dhabi (oil helped too) and the market responded favorably by bouncing back. So, why does a market correction matter?

Honestly, I don’t think it does. It’s valuable to know that you’re 10% away from highs because you’re now no longer talking about the random walk and starting to discuss trends. A few percent either way can be considered part of the noise, 10% starts getting you thinking because 10% is more than can be considered standard deviation. However, outside of knowing you’re 10% away from highs, I think it’s not terribly important to know that a “correction” has occurred. The reason I say this is because you don’t know, at that exact moment you recognize a correction has occurred, whether you’re going to continue to trend downwards or bounce back.

On Tuesday, the market bounced back by tacking 1.69% back onto the Dow. Tuesday easily could’ve been a day in which we saw larger losses. Tuesday easily could’ve been a day in which we saw smaller gains or losses, we simply cannot see the future and thus cannot make any decisions that we’re 100% confident in. It’s kind of like the cup and handle technical indicator [3], as great as past performance may be, it’s not an indication of future performance.

What can you take away from a market correction? I think that if you have money on the sidelines that you’ve been holding off on putting into a market, seeing a market correction might be a good time to buy back in. The only thing you can be confident about is that you aren’t buying at the highs of the market. While you might be buying while the market slides down that slippery slope, at least you know you didn’t buy at the highs of the market.

Beyond that, I don’t think you can really take much away from knowing a market correction has occurred.


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