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Make fear and greed work for you

Wall Street constantly swings between these two emotions. You can either get caught in the frenzy - or profit from it.

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By Janice Revell, Money Magazine senior writer

After hitting an all-time high during the early days of the financial crisis, investors' expectations about the near-term riskiness of the market have dropped sharply, as measured by one common indicator of investor fear
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(Money Magazine) -- Fear and greed.

Those are the emotions that rule the markets, and changes in stock prices simply reflect the swing of the pendulum between the two extremes. Only lately the swings have arrived with more violence than a Transformers movie.

First came fear, specifically of a financial system meltdown. That triggered one of the sharpest stock selloffs in history last fall as banks lost confidence in one another, institutional investors started dumping assets and highly leveraged hedge funds unwrapped their positions to raise cash.

When it was all over, the Standard & Poor's 500 had lost 45% in six months. Greed reappeared in the spring, as bargain hunters swept into stocks at the first tentative signs the crisis might be easing. That led shares to surge 39% from March to June, the best three-month gain in the S&P since 1933. In recent weeks prices have retreated again. Who can blame you if you're feeling whipsawed and now wonder, What's next and what am I supposed to do about it?

And therein lies the real problem: Crazy markets can drive you to do dangerous things. Warren Buffett calls fear and greed "super-contagious diseases." If you catch either one, you risk serious damage to your financial health.

Exhibit A: In the two months following the collapse of Lehman Brothers last September, shareholders unloaded a staggering $120 billion of their stock funds - more money than had flowed into those funds during all of 2007 and 2008. But selling at that point merely turned paper losses into real ones, and kept many people on the sidelines when stock prices took off again.

Exhibit B: During the first two months of the spring rally, investors flocked to high-risk stocks, plowing more money into emerging-market funds than they put into U.S., European, and Japanese stock funds combined. Clearly they had short memories or very forgiving natures, since those funds collectively lost about two-thirds of their value - far more than the average stock - during the market's most recent swoon.

This renewed appetite for risk doesn't seem to be letting up, either among the pros or individual investors. "No respectable fund manager likes being beaten by a rising average," says York University economics professor Jonathan Nitzan. "So you get 'panic buying' - a frenzied attempt to jump on the bandwagon before the really large gains are gone."

Meanwhile, in a recent CNNMoney.com survey, more than half of the 40,000-plus respondents reported that they planned to add to their stockholdings over the next few months, and nearly one in five intended to do so aggressively. Greed trumps fear, at least for now.

But just because everyone else is lining up for the roller coaster doesn't mean you should too. The ride will inevitably be rough, and you could get hurt. Instead, you need a strategy to keep you on a steady course - that is, a way that you can profit from the fear and greed of others without being sucked into it. These actions should help.

1. Don't try to know the unknowable

When TV's talking heads and all the "smart" people you know start crowing about a particular strategy - whether it's loading up on growth stocks or running for cover in cash - you naturally assume they know something you don't. You probably also subconsciously place more weight on recent events, and so figure that whatever the current trend is, it will probably continue - if stock prices are rising, you're apt to think they'll continue to rise for at least a while more, and vice versa. Behavioral financial specialists have dubbed this phenomenon recency bias.

The rub: Neither assumption is true. The experts don't own a crystal ball, and past performance is no guide to future returns. Remembering that can help keep you grounded when emotions are running high in the market.

Like now. Judging by the massive inflows into stock funds lately and the sharp price gains of the spring, you might conclude that values will keep rising for a while, especially since the threat of a collapse of the financial system seems to have passed. Yet history shows that prices are more likely to pull back following big rallies off bear market lows.

Looking at similar advances over the past 50 years, Sam Stovall, chief investment strategist at Standard & Poor's Equity Research, found that, on average, stocks subsequently lost 7%; if the rally came after a "mega-downturn," prices dropped 14%. If that happens again, stocks would ultimately give up about half of their recent gains.

As for where stocks would go after that, the outlook is murkier. History suggests further gains ahead: Over the past century, the average big rally in a period of generally falling prices saw the market rise 64% in 18 months; if the rally turned out to be ushering in a new era of generally rising prices, stocks shot up more, 110% on average, over nearly three years, according to Ned Davis Research.

But history is a spotty guide at best. And the current financial downturn, the deepest since the Great Depression, is hardly typical. The staggering amounts of money that the U.S. and other governments have been pouring into the recovery effort are so unprecedented that you are "reduced to guesswork" when it comes to gauging how effective they'll be and what impact they'll have on the markets, says veteran money manager Jeremy Grantham.

The moral: Forget trying to divine the unknowable (like the future direction of stock prices or how long a bull or bear market will last). And don't believe anyone else who appears to know the outcome either.

2. Focus on what can go wrong, not right

When greed is gripping the market, the question that typically drives investment decisions is, How much money can I make on a particular stock, or can I make a killing by placing a bigger-than-usual bet on a hot sector of the market? A better question to ask: How much money could I lose?

Look at what can happen, for instance, if you make an outsize bet on stocks. T. Rowe Price crunched the numbers for a 50-year-old with $175,000 in his retirement account who decides to shift his entire portfolio into stocks. (The researchers also assumed the investor contributes $15,000 a year to the plan, adjusted annually for inflation.) While the investor typically had more money in his portfolio by age 65 than he would with a more conservative mix, 15% of the time he actually ended up with less. And even when he came out ahead, the additional profit was often quite modest - typically about $50,000 on a portfolio of nearly $1 million.

"It's tempting to focus on what you'd get if you hit a home run, but the additional risk you take with a concentrated stock portfolio just isn't worth it," says Christine Fahlund, senior financial planner at T. Rowe.

Making matters worse, the big stock bet would be far riskier on a year-to-year basis than other strategies. The most common measure of portfolio risk is standard deviation, which tells you how much an investment's short-term returns bounce around its long-term average. Since 1926 stocks have returned average gains of 9.6% a year, with a standard deviation of 21.5 percentage points, according to Ibbotson Associates. That means that about two-thirds of the time, the annual return on stocks landed 21.5 percentage points below or above the average - that is, in any given year, your results would range from a 12% loss to a 31% gain. You'd need either an iron stomach or a steady supply of Zantac to stay the course. And if you happened to be at or near retirement when one of those really bad years hit, you might have to rethink your plans.

Running for cover when fear overtakes the market turns out to be a losing proposition too. True, you'd avoid the wild ride: Ibbotson found that returns on an all-bond portfolio typically fluctuate less than eight percentage points off the long-term average annual gain of about 6%. But you're likely to end up with a lot less money - about 15% less than you'd earn over 15 years with a more diversified portfolio, according to T. Rowe, and possibly 30% less. That's a big hit, especially for anyone close to retirement.

Moreover, these results assume a 3% inflation rate; if inflation were to rise - a scenario that could come to pass, given the country's massive budget deficit - the all-bond portfolio would lag even further behind, since bond prices typically get hammered when the consumer price index shoots up.

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