Why the Stock Market Makes Corrections

Stock prices can be volatile. From day to day, the price of almost every stock in the world fluctuates, sometimes significantly. When the stock market as a whole goes down by at least 10 percent, the sell-off is technically dubbed a correction. While hardly any investors want the market to sell off, this is a regular feature of the markets as a whole. Several factors can contribute to or even create the conditions for a correction.

Earnings

Over the long haul, the direction of the stock market as a whole follows corporate earnings, which then affect companies' stock prices. When earnings are projected to rise, the stock market typically follows suit. On the flip side, when earnings fall, so do stock prices. If a few companies don't meet their earnings projections, it's not usually enough to trigger a widespread market correction. However, if the overall global economic outlook dims, many companies will be affected. When groups of stocks begin to sell off, the market as a whole usually goes through a correction.

Tax Loss Selling

Tax-loss selling often comes into play at the end of the calendar year, when investors often make investment decisions based on tax consequences. The Internal Revenue Service allows you to use losses from stock trades and other investments to offset any capital gains you have. If your company ends the year with large gains in your portfolio, you might consider selling your losing stocks to offset your gains, thereby avoiding taxes. If enough investors have losses, year-end selling can trigger a correction in the market as a whole.

Technical Analysis

An entire branch of stock market analysis, known as technical analysis, is devoted to tracking the trading patterns of individual stocks and the market as a whole. Based on the past performance of stocks after they trade in particular patterns, technical analysts try to predict future price movements. If stock charts indicate that a group of stocks, or the market as a whole, is in a pattern that has historically resulted in a correction, investors who subscribe to this philosophy will sell stocks. When enough investors sell stocks, a correction occurs.

Fear

As scientific and sophisticated as the stock market might seem, it is still driven to a large degree by emotions -- particularly fear and greed. When investors get scared, they sell stocks. Oftentimes, selling can snowball, as investors panic when they think they won't be able to get out of their stocks at a decent price. Sometimes it's simply a rumor that triggers fear in the marketplace; other times it is just a feeling that the market has gone up too high, too fast. In that case, profit-taking can cause a correction in the overall market.