Simply defined, price correction in stock market refers to the phenomenon wherein inflated stock prices fall by around 10% from their 52-week high. This inflation in the price is generally caused by investors who anticipate gains and purchase shares in bulk, while the fall is caused due to investors selling their shares and cashing in on their profits. In other words, price correction refers to a decline of a minimum of 10% in price of a market index or security, following a temporary boost in market prices.
What causes price correction in stock markets?
A stock market’s value is always going up and down. Sometimes, the market will experience some short-term gains, even though in reality, nothing has changed. In stock markets, investor psychology plays a major role in driving prices up and down. There are two major reasons for a price correction:
- Incessant buying in anticipation of gains: Whenever an investor anticipates greater profits, they are bound to buy more units of the security. In doing so, these investors drive the demand of the security up. This rise in demand corresponds to a rise in the price. Now, because the investors are still anticipating profits, they will continue to buy more units. For example, the original price of share is about Rs80. Due to incessant buying, this price goes up to Rs100. This buying will go on till a point of time where buying slows down due to ridiculously high prices. This is where the second reason comes into play.
- Profit booking: In this game of security prices, there is always a point wherein the investor decides that the price won’t go further ahead, and thus decides to cash in on the profits. When investors start selling their securities, the prices fall down. In the previous example, investors now start dumping their securities in the market at a profit of Rs20 (assuming they bought at Rs80 and sold at Rs100). This is known as profit booking. This will go on till the prices start to fall. Let us assume that the price falls down to Rs90. This is a decline of about 10% from a 52-week high price of Rs100, and is thus known as price correction in the stock market.
How should you ideally react to price corrections?
Market corrections or price corrections are gut-wrenching. A lot of novice investors pull out of the stock market due to fear of losses. Exiting the stock market is the worst thing you could do when the market is correcting itself. Here’s why.
Losses incurred due to correction of stock markets are generally recovered within three months. Remember, market corrections are completely natural and occur due to consumer psychology. If you sell during the correction, chances are you won’t buy in time so as to make up for your losses.
In order to protect yourself from losses due to market corrections, there is one golden rule that you must follow. Ace investor Warren Buffet phrases it this way, “Never put all eggs in one basket”. A diversified investment portfolio is the best protection one can have against market corrections. A diversified investment portfolio means investing your money in various places such as stocks, bonds, commodities, etc. If you are a beginner, it is best that you go to a financial planner/advisor for more advice on balanced and diversified portfolios.