Q: Ive been planning to invest a large amount of money in a Vanguard index fund. Just when I was ready to fill out the forms the Dow Jones industrial average started to fall and alarming news stories were calling it a correction. Can you explain correction and what I should do about it? Is this temporary? How will I know when its over?
A: The term correction, is one of three words that investing professionals use to help people understand just how scary, or damaging, a stock market plunge might be.
The stock markets three categories for losing money are pullback, correction and bear market.
A pullback is mild. It might make you nervous as the damage is being inflicted to your money, but it will blow over quickly. You might lose 5 to 9 percent of your money, but the losses will heal quickly. Within a few weeks you might not even remember that it happened. By the end of the year if you look over your 401(k) or IRA, the short-term losses probably will be indiscernible.
Thats true of a correction too, although when you are in the midst of one, it will be scarier and you will wonder if it will become more destructive. In a correction, you temporarily lose 10 to 20 percent of your money, maybe over a couple of months. But on average you are back to even in four months, according to Standard Poors research.
The trouble with a correction, however, is that you never know when it will be over, and a correction can morph into a bear market.