What is a market correction?

By definition, a market correction is when a stock or market index falls by more than 10% from its most recent peak. This happens when investments are sold on a mass scale and causes share prices to fall.

Market corrections come in different shapes and sizes, and for different reasons. But typically, they occur when investors become less optimistic about the market outlook due to influencing factors such as economic data, geopolitical events and market volatility.

What caused the recent market sell off?

The recent market sell off started on Friday 2nd August, and the start of this week has started in a similar vein. On Monday, the S&P 500 (which comprises of the 500 biggest US companies) and the tech-heavy NASDAQ 100 were down by 4.5% and 6% respectively at market open. In the UK, the FTSE 100 index is down by 3% and the Nikkei in Japan is down by 12%.

The sell off was a reaction to a weakening economic outlook in the US - weekly unemployment claims rising to almost a one-year high and manufacturing output coming in lower than expected. But, with US growth decelerating, a slowdown in economic data was to be expected.

The US Fed Reserve unanimously decided to hold interest rates at a two-decade high of 5.25% to 5.5% at the last meeting on 31st July. With the Fed’s Chair, Jerome Powell, hinting that an interest rate cut could be on the horizon, but “we are not quite there yet”.

With the benefit of hindsight, the Fed would likely reverse that decision based on what they know now, but recent events should give them the green light to cut interest rates during their next meeting in September.

The recent events highlights how quickly things can change in financial markets, so here are five top tips on how to invest during a market correction.

How to invest during a market sell off

1. Don't panic

After a market crash, emotional reactions will mean that price falls will often be exaggerated. It’s part and parcel of investing and should be expected from time to time – indeed a well known City adage goes, “market rise up the stairs and go down the elevator”.

Gently rising markets tend not to make newspaper headlines, but precipitous falls do – and it all adds to the general sense of fear. In the long run, markets are driven by company earnings, so think rationally about your investments. During a market-sell off when share prices are volatile, buying or selling in haste can result in being on the wrong end of price swings.

2. Get some context

Although there might be more questions than answers at the time, a market sell-off can often help you think about the impact on individual companies or sectors. Are profits now under more pressure? What are the opportunities given the change in the landscape? What are the threats?

Also, try to get a sense where valuations are relative to history. Think about whether valuations compensate you for the risks. Following a large market fall an overly pessimistic scenario may already be reflected in prices - and there could be a bounce as greater certainty or assurance is provided.

3. Diversify your investments

During a market sell-off where large swathes of shares are being sold, it might seem intuitive to focus on one type of company or one sector. But piling investments into one area is likely to increase the risk of volatility in your portfolio. Investors typically build portfolios of various shares and other assets so that they are not overly reliant on any one investment or asset class performing well – this is known as diversification.

Holding a variety of investments from different areas around the world also can spread risk out, so you don’t have all your eggs in one basket. If you do decide to invest overseas, be sure to learn the extra risks such as currency exchange movements and charges.

4. Stick to the plan

Hopefully you already have a plan in terms of how much money you are investing, or seeking to invest, and which areas it is allocated to. Market volatility will test your resolve, and in some cases you might question your decisions. Perhaps a market sell-off has revealed you have too little diversification, or you are taking too much risk. In these instances you may wish to make changes.

However, if your plan is a sound one (a well-diversified portfolio with a decent amount of cash for emergencies), it often makes sense to do little or nothing.

5. Use market falls to your advantage

We all know we should be buying when asset prices are low and selling when they are high. However, this is hard to achieve and many people end up making emotionally-led decisions and doing the opposite. A large fall in the markets could be just the opportunity you have been waiting for to invest in an area you have had your eye on but felt was too expensive.

If it is still too much of a leap of faith consider averaging in - buying your shares or units in stages over time or by setting up a monthly investment amount. The latter takes away any consideration of timing the market, which can be a relief.

Market sell-offs when combined with other factors can lead to an economic recession. Be sure to check out the article below if you’d like to pick up more insight on this: How to invest during a recession