Some of the common questions that most investors ask, “When will a correction happen or How deep will this correction be?” 

The other day, I was having a conversation with a friend who asked me “Why is it called a Correction?”  I thought it was a pretty simple, but a smart question. That made me realize that most investors including professionals start using some words and it becomes a part of their conversations as well as decision making. Waiting for a Correction is a game played by many investors and it is almost become an accepted way of investing.

Thus, I decided to test this word with a few investors (some real sophisticated ones) and a few advisors by asking them “Why is a decline in prices called a Correction?”

Most said that it means that the stock markets or stocks correct in value. One person was very specific and said that correction means a stock market index going down by 10% in value. I told them while all of you said what it means my question was about “Why is it called a Correction?”

There were not any answers to this why, so I will attempt to answer not just the why but also why it needs an upgrade.

Generally, there is no real investing textbook definition of a correction.

Investopedia explains a correction as follows “In investing, a correction is a decline of 10% or more in the price of a security from its most recent peak. Corrections can happen to individual assets, like an individual stock or bond, or to an index measuring a group of assets. An asset, index, or market may fall into a correction either briefly or for sustained periods—days, weeks, months, or even longer. However, the average market correction is short-lived and lasts anywhere between three and four months.”

My understanding of the “Why is it called so?” was very simple. When the stock market or any asset declines, it is assumed that the prices have declined (corrected) to its fair value.

3 Questions to ask yourself:

1. What if the asset is already below the fair value and there is a decline, would you still call it a Correction?
2. What if the same undervalued asset goes up towards fair value, would you still call it a Correction?
3. What if an asset is already at fair value but it goes up and down, does it still make sense to call this decline a Correction?

The objective of this post was not to do a PhD on Corrections or to demonstrate superior knowledge on Corrections but to empower you with the right vocabulary and thoughts when it comes to investing.

Like I have said, Waiting for Corrections is a game or strategy followed by investors. It seems that even Warren Buffett does so. The point is that he is not waiting for corrections with all of his money (100% cash). He is always invested in the stock market, but his cash levels can vary from 10% to 30% because of various reasons such as cash generated by his company Berkshire or if he believes that the markets are extremely overvalued or when there are no opportunities for his size of investments.

Markets and assets can be fairly valued, overvalued or undervalued at different points of time. Valuation is a very complex subject and is not just a science but an art as well. Science provides the frameworks, tools, and methods while the art is to interpret this in a meaningful way. Remember most analysts get this wrong so do not waste your time obsessing over valuations and corrections.

Wharton Professor and Author of the Classic “Stocks for the Long Run” Prof. Jeremy Siegel shares his thought that 90% of a stock value comes from earnings beyond the next 12 months earnings. So even if the next 12 months earnings are zero, assuming the company will resume normal earnings after 12 months, it’s value should typically decline by 10% or less. 12 months of zero earnings is an extreme case for most listed companies (we are not talking about the restaurant that closed down or local business that is shut) and this will be reflected in the first quarter results itself (where you will see some public companies still showing profits despite the lockdown). Even if you assume this extreme case of 100% of zero earnings for 12 months, technically value should decline less than 10%. However, market reactions are crazy and we saw a sharp decline of 40% swiftly in March only to recover 40% from the low it made in March (Sensex recovered from its 25000 lows to around 35000 today though still down by 17% from its peak of 42000+ ). Some people are still waiting for a correction (sorry: decline) to happen whereas many have been investing through the fall.

I have always maintained that there is no way to precisely time the bottom (buying lowest) or your entry and exit from the stock market (market timing). Wise investors know that the only way to make money is to buy low, be invested and keep some liquidity to buy low should the market decline further.

Finally, you would do well to understand the quote by the legendary Peter Lynch “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.“