When you examine stock market charts, you can see that stock prices never go up in a straight line. They rise and fall on their way to higher prices. Experienced investors consider this normal. However, you may also notice larger dips in some places, indicating that people began selling stocks so quickly that prices dropped as much as 10 percent. A 10 percent dip qualifies as a market correction. This can be as normal as other dips, but if you don’t understand the phenomenon, it can be alarming.
When the stock market rises rapidly in a nearly vertical direction, experienced investors start watching for a correction. In this case, the correction is necessary because too many people are buying just to get in on the action rather than because they have studied the fundamental fiscal condition of the companies involved. At some point during the rise, an investor will sell to take profits, and those who follow trends will sell as well, driving the price down. Once the speculators have been “corrected” out of the market, calm investors can buy and expect a steadier and less rapid period of growth.
Lack of Buyers
Once the stock market rises for a long period of time (there is no set amount of time), everyone who wants to own stocks has already bought them. When the market runs out of buyers, sellers will have trouble finding someone who wants their shares. Those sellers will start lowering prices until they find a buyer. This can result in a correction of 10 percent, if other sellers fear that they will lose their profits. They will join in the selling, and reluctant buyers will wait for a low price.
Some investors make their money buying stocks when they go into a correction. These investors buy when everyone else is selling, thus getting a lower price as the correction nears its bottom. This can be risky, because every 10 percent drop is not a mere correction. Some 10 percent drops signal the beginning of an even deeper sell-off. Investors who buy dips have confidence that the overall market is healthy and simply needs a correction to get rid of investors who don’t understand the market.
Sometimes the stock market rises because so much good news comes out about the economy and then investors flock to buy. This kind of euphoria can drive prices unnaturally high. At the top of such a move, almost everyone agrees that stocks are the place to be. Experienced investors know that when no one is skeptical, a correction is due. Stock market peaks and valleys are a record of a never-ending battle between optimists and pessimists. Those conflicting views keep the market from rising in a straight line.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.