The Psychology of Market Corrections- Five Insights

The psychology of market corrections is something many everyday investors still fail to prepare for well. In recent years, stock market corrections have become more frequent, yet we see everyday investors still making the same mistakes. In this article, we will give you five important insights to help you better handle and deal with market corrections. This alone can make a significant difference to you long term success.

  1. Expect the Unexpected

If you are new to the financial markets, you may not have experienced a significant market correction since the GFC of 2008/9. Newcomers have therefore enjoyed some mild downturns in the last 8 years, but not a major correction, yet.

Seasoned investors know corrections are to be expected. In fact, often through bitter experience, they have learned to expect the unexpected, and they prepare for them. They also know that where there is pain, there is gain.

  1. Understand Market Cycles

Secular Bull Markets, as they are called occur usually every 7-10 years approximately. Professional investors study the underlying fundamentals and the technicals (chart patterns) intimately, so we can identify whether we are in a bull or bear market. However, the uncertainty is the turning points- no one can anticipate (never predict) this accurately and consistently. In fact, global markets and digital communications have made this task even more difficult in recent years.

For the everyday investor, you should study Global Money Flows, which we have written about earlier. In addition, studying the major charts of your stocks, or the relevant indices, or other global markets is most important.

In fact, if you go back and deeply study the major corrections over the decades, you will see patterns, and you will also be able to validate accurately uptrends, downtrends and non trending markets. Above all, you will see links between the fundamentals and the charts. When you combine these analytical tools, you gain a major advantage in the markets.

  1. Risk Management

All traders and investors who are successful have mastered strong risk management. If you are a newcomer, and have not developed your systems or approaches here, the time to do this work is now.

Risk management is a broad area, but the key things you should cover include:

  1. Stop Loss Placement- how to set them, and whether they are ‘soft’ or ‘hard’ – the latter being an actual order in the market. After setting them, how you will execute them, particularly if they are ‘soft’, and if there is a fast market correction which catches you by surprise.
  2. Position Sizing– what will be the size of your trade or investment? This relates to your investment or trade risk, which is quantified through your stop. This risk is then linked to Maximum Capital Risk (MCR) which is commonly 1-2% of your capital base. Things will be quite different for traders and investors. However, sizing and quantifying, to the dollar, risk per position are important things that must be done.
  3. A Fast Market Correction– what will you do if the market drops sharply, say 20% or more in one day! This can and has occurred, for instance on Black Monday, 19 October 1987 when the Dow fell 22%. In your investment or trading plan you should have a rule or guideline that ensures you do not panic. For example, you will hold and wait for clarity at both the fundamental and technical levels, and if you are to exit positions at all, you might do so on the first retracement wave, or bounce in the market after a sudden correction. Remember, there is no one approach or golden rule here. Things will vary with your strategy, your mindset and your longer term objectives.

 

  1. Portfolio Re-balancing

For investors who have a balanced portfolio, say with growth stocks and bonds, or defensives, you will need to consider re-balancing of your portfolio, hopefully before any market correction.

In fact, regular re-balancing, say annually or bi-annually can act as an inherent safe-guard against being over-exposed in risk markets such as stocks in the event of a correction.

For example, if you hold a traditional 60% : 40% portfolio split between stocks and bonds, and if you have maintained this since 2008 and re-balanced annually, then by now you should not be over-weight in stocks. If there is a fast correction, then you have an inherent safeguard with your defensive bonds already in place.

  1. Do Not Focus on the General Media

When there is a significant market correction the general media is all over it. They amplify the noise and often can induce panic. Seasoned investors know not to pay too much, or any, attention to the general media. Seasoned investors look for quality, professional and independent data to base their decisions.

Seasoned investors will follow the rules and guidelines in their written plans and will not panic. They have learnt to separate the noise from the evidence.

The psychology of market corrections is one we all must deal with. During market corrections the amateurs are quickly separated from the professionals. It is often at these precise times, where ‘there is blood in the street’, amateurs sell to professionals who have bought quality stocks cheaply and so they are ready for the next bull market.

 

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