Price correction in the stock markets refers to a phenomenon where inflated stock prices fall sharply after reaching record highs. This inflation in the stock prices is generally caused by investors who anticipate gains and purchase shares in bulk, while the fall is caused due to investors dumping their shares and cashing in on their profits.
What causes price correction?
A stock’s value is ever-changing. Sometimes, the market experiences some short-term gains even if nothing significant has happened. Investor psychology plays a major role in driving prices up and down in the stock markets. There are two major reasons behind price correction in stocks:
- Incessant buying in anticipation of gains: Whenever an investor anticipates greater profits, they are bound to buy more units of the security. In doing so, these investors drive the demand for the security up. This rise in demand corresponds to a rise in the price. Now, because the investors are still anticipating profits, they will continue to buy more units.
For example, the original price of a share is about Rs80. Due to incessant buying, this price surges to Rs100. This buying spree will continue until ridiculously high prices stop investors from purchasing more units.
- Profit booking: There always comes a point in time where the investor decides that the price won’t rise any further, and thus, decides to cash in on the profits. When investors start selling their securities, the prices react and fall. Citing the previous example, investors are now dumping their securities in the market for a profit of Rs20 (assuming they bought the shares at Rs80/apiece and sold them at Rs100/apiece). This is known as profit booking. This will go on until the prices drop by a significant margin.
How should you ideally react to price corrections?
Price corrections can be gut-wrenching. A lot of novice investors pull out of the stock market due to a fear of losing money. However, exiting the stock market is the worst thing you can do when the market is correcting itself. Here’s why:
Losses incurred due to price correction can generally be recovered within a few months. Price corrections are completely natural and happen as per the investor sentiment. If you sell during a correction, there are chances that you won’t be able to buy more units of the same instrument at a lower price in time so as to make up for your losses. A diversified investment portfolio is the best protection one can have against corrections. Diversification means investing your money in various instruments such as stocks, bonds, commodities, etc., to ensure that sector/industry-specific corrections do not affect your entire portfolio.