A stock market correction is caused by some kind of event that creates fear and subsequent panicked selling. It can be a gut-wrenching time, and many beginning investors will feel like joining the mad dash to the exits. However, that's exactly the wrong thing to do. Why? The stock market usually makes up the losses in three months or so. If you sell during the correction, you will probably not buy in time to make up your losses.
Corrections are inevitable. When the stock market is going up, investors want to get in on the potential profits. This can lead to irrational exuberance. This can make stock prices go well above their underlying value.
A correction is different from a stock market crash, which is when stock prices plummet more than 10%, often in just one day. Unlike a correction, a stock market crash can cause a recession. How? Stocks are how corporations get cash to grow their businesses. If stock prices fall dramatically, corporations have less ability to grow. Businesses that don't grow will eventually lay off workers to stay solvent. As workers are laid off, they spend less. Lower demand means lower revenue. This means more layoffs. As the decline continues, the economy contracts and you have -- Voila! -- a recession.
If a correction is relatively benign, and a crash can cause a recession, how can you tell the difference? It's not easy. A correction can turn into a crash if the stock market declines more than 10%. Trying to decide if a correction is turning into a crash is known as timing the market. This is nearly impossible to do, since there are so many factors that can influence the direction the market goes in. That's why the best strategy is to have a diversified portfolio with a balanced mix of stocks, bonds and commodities. You will profit from market upswings with the stocks, and be protected from stock market corrections with the bonds and commodities. With diversification, you will feel safe to ride out any stock market corrections.