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Why Market Corrections Are Healthy

Why Market Corrections Are Healthy

Explainers Trading

16 Mar 2021

Seeing the assets in your portfolio dip severely can be nerve-racking and scary, but in fact it’s completely normal and part of basic market dynamics. In fact, market corrections are typically a sign of healthy markets as the price returns from an abnormal surge to its long-term established trend.

There is no concrete rule that defines what constitutes a correction, but most traders consider a rapid decrease of 10% in the price of an asset from a recently achieved peak a correction, and anything above 20% signals a potential trend reversal (although in Bitcoin, this may be more like 30%).

How often do market corrections occur?

In the last 100 years, the S&P 500 Index has on average seen a minor 5% correction 3 times a year, a 10% correction once every 16 months, and a severe 20% crash every 7 years. On average, corrections last 43 days.

The most recent severe plunge was in early 2020 when the coronavirus pandemic sent investors fleeing, but within 5 months the Index made a full recovery and was on to setting new record all-time highs.

Crypto assets are far more volatile than anything we’ve seen in traditional equity markets. Corrections in the 5-10% range are more common, and severe 20% corrections certainly happen more than once a year. At the same time, frequent corrections are balanced out by similarly frequent recoveries. For example, early March 2021 BTC fell 12% in just 2 days but recovered and broke the previous high just 4 days after that.

How to handle corrections

As the famous Bill Lipschutz said: “If most traders would learn to sit on their hands 50 percent of the time, they would make a lot more money.” However, that’s not what most traders do. Instead, the majority of crypto traders try to anticipate corrections by selling the top and buying the dip.

Although it’s certainly possible to make profits swing trading, making short-term gains trading the ups and downs of the market, timing the market consistently right and sticking to a strategy that is effective rarely works out in the long term. Most people lack the discipline to stick to a winning investing playbook in correcting markets, but they also tend to transact at the wrong times, causing even larger losses.

But if you’re trend trading instead, HODLing crypto assets playing the long game, market corrections are of less interest to your strategy – although it might help timing a dollar-cost averaging strategy. Nonetheless, watching a severe correction minimize all the gains you’ve secured over a long period can be nerve-racking.

With a row of red candles worthy of a royal funeral staring you in the face, it’s critical to keep in mind that corrections are normal, expected, and healthy for long-term continued growth. Even in traditional markets, financial planners expect one out of every four calendar quarters to yield negative returns.

Taking a broad view, the way to limit the impact corrections have on your portfolio is by diversifying across asset classes and industries both in a geographical and an operational sense. For example, the rotation seen in tech stocks that started in Feb 2021 was pretty severe, however stocks, in financials, transportation and retail were unaffected.

In a narrow sense, within the crypto section of your portfolio, there isn’t a lot to do if you are investing with a long-term view. Many of the top crypto assets have somewhat similar price dynamics, so for the purposes of hedging against corrections there is no real way to diversify your way to safety. You could set Stop Loss orders at certain levels to set boundaries as to how much you are willing to lose in a severe correction.

But beware the sharp needle – your sell orders could get snapped up during a flash crash and you end up selling good positions for no reason.

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