A Primer to Market Downturns

All market slumps are not the same. Here is how to recognize different types, and what they mean.

If you're like many Canadians, you've been getting nervous about your investments because of the rapid up-and-down swings of the stock markets. To help you understand and cope with these market swings, let's take a look at the different types of downturns.

A decline - usually lasting a few weeks to a few months - is a short-lived sell-off by investors in reaction to some unexpected bad news. An example was the 554-point drop (a 7.2% decline) in the Dow Jones Industrial Average, one of the most closely watched indexes, in October 1997. Fears about how the weak Asian economies would affect earnings expectations in North America resulted in significant "knee-jerk" selling. Soon, however, the Dow adjusted itself, and it ended the year higher than it had started.

When a decline approaches the 10% level over a short period of time, such as a few days, it's usually considered a correction. Corrections can be caused by significant increases in interest rates, reductions in overall economic activity, or perceived overvaluations of stocks. A severe correction can occur as a result of a particularly negative political event. For instance, the Dow fell 21.2% over a three-month period after Iraq invaded Kuwait in August 1990. Interestingly, in a study of the Dow's movement since 1900, Ned Davis Research, a financial research company, found that severe corrections are followed by "bear" markets 58% of the time.

Bear markets
A bear market is a prolonged period of declining stock values that can last a year or longer. The market is considered "bear" when stock prices fall about 20% or more and stay down. Broad economic factors, such as unfavourable interest rates and an economic slowdown, trigger a self-perpetuating spiral of selling. This is in contrast to a "bull" market, which is a prolonged period of rising stock value.

Much less common than the above is a crash, when stock prices drop more than 10% in one or two days, resulting in severe sell-offs by scared investors. Only two crashes occurred in the last century: The first was on October 29, 1929, and the second on October 19, 1987. Usually, a crash is caused by a dramatic reversal of basic market assumptions. Although not a "crash," the financial crisis of 2008 caused the Dow's worst-ever week: Starting October 6 of that year, the index fell 18.1%.

Whether it's a brief decline or an extended bear market, you can use some simple strategies to see a downturn through. A long-term focus, combined with a well-diversified portfolio, will ensure that the bumps along the way don't derail your plan.