Keep your cool in a dangerous market

With every dip in the Dow, that inner voice urging you to sell gets louder. Here are four reasons you shouldn't listen.

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By Janice Revell, Money Magazine senior writer

Reason No. 1 Your brain is wired for panic.
Risk Tolerance
How much uncertainty can you stomach?
1. You have $10,000 invested in stocks and mutual funds. The past quarter has been rough -- the value of your holdings has dropped by 20 percent. You:
Cash out what's left and stow it under your mattress.
Move all your money to a government bond fund.
Do nothing. You're sure the market will rebound in the long run.
Pour another $10,000 into the stock market. After all, it's cheap!

(Money Magazine) -- Don't give in. Pros have all sorts of clever computer models for assessing risk. But even those brilliant machines misjudge risk from time to time (like in the subprime meltdown).

So how can the rest of us expect to be right on risk when all we have to work with is that carbon-based computer we keep between our ears? "Most people just can't think about risk in an analytic way," says Paul Slovic, a University of Oregon psychologist and an authority on how we assess risk. "The average person goes by gut feelings."

As behavioral scientists have proved, those feelings are notoriously unreliable in a market like this. Part of the problem is that your brain evolved to feel the pain of loss more acutely than the pleasure of gains.

That means that the normal human reaction in a downturn is to turn fearful and sell - even though risk is lower than it was when stocks were higher and the rational move would be to buy.

"We always say 'Buy low and sell high,' " says John Nofsinger, a finance professor at Washington State University and author of "Investment Madness: How Psychology Affects Your Investing." "But after the market has gone down for a while, the 'buy low' option is just not emotionally available to most people."

Obsessing over every bit of market news only raises the odds that you'll overestimate risk, according to behavioral economist Richard Thaler of the University of Chicago. The more often you check stock prices, he found, the greater you perceive your risk to be.

Prices move up and down pretty much constantly. If you're watching that activity minute by minute on your PC or TV, your brain gets the message that it's dangerous out there.

A simple, effective way to lower your anxiety: In Thaler's experiment, the subjects who perceived the least risk were those who checked their investments no more than once a year.

Reason No. 2 You see safety in the herd.

It's an illusion. Faced with uncertainty, your instinct is to follow the crowd. Bad idea.

"The herding tendency clouds your judgment," says UCLA finance professor Subra Subrahmanyam. "If others are selling, you'll be prone to ignore your own assessment and sell as well." Economists dub this progression "information cascading." You might call it a lemming parade.

The record of mutual fund cash flows shows that the crowd's investing moves are a reliable indicator of what not to do.

The great manager of FPA Capital fund, Robert Rodriguez, notes that the largest fund in 2000, as stocks were peaking, was growth star Fidelity Magellan. Three years later the new darling had become bond fund Pimco Total Return, just as bond returns peaked. "You can't make this stuff up," he marvels.

Today's fund cash flows suggest that you should buy stocks, since stock funds saw a net $44 billion withdrawn in January, and should avoid bonds and commodities, which saw multibilliondollar inflows.

Sure, it's not easy to hang on to stocks when everyone around is bailing or to avoid buying bonds or commodities when others are cashing in. But if you do, history suggests that you won't regret it.

Reason No. 3 You underestimate the risk of being out of stocks.

These days it's helpful to remind yourself of this: In the long run the risk of missing stocks' upside poses a graver threat to your wealth than taking hits on the downside does. There's no denying that the big one-day drops we've seen recently are no fun, but if you hang in, the math works in your favor.

"Stocks go up and down," says Stephen Wood, senior portfolio strategist at Russell Investment Group. "To make money you need to capture their upward movements. The only way to do that is to stay invested in dicey times."

Don't kid yourself that if you flee stocks now, you can slip back in just in time for a rebound. Years of data and volumes of research have proved that not even the pros can time the market with any consistent success. Focus instead on the fundamentals.

When the market plunges, so too do price/earnings ratios. And the cheaper you can buy, the better your chances of making money in the future. For proof, consider the crash of October 1987 and its aftermath. Had you owned an S&P 500 index fund, you would have lost 23% during that month, including a stunning 21% on Black Monday, the 19th.

Had you sold, you would have locked in that loss. But had you stuck it out, you would have gotten back to even in 20 months. And then you would have participated in the great bull run that followed, racking up an annualized 15% return over the next 10 years.

Sticking to your guns was psychologically no easier 20 years ago than it is today; but the results suggest that the investors who will look the smartest in a few years won't be the ones who are now jumping out of stocks and plunging into commodities.

Reason No. 4 There's no such thing as 'risk tolerance.'

Open a brokerage account, click around your 401(k) provider's website or consult with a financial pro and you're bound to come across a questionnaire that tries to assess your appetite for risk.

You might be asked what you'd do if the market dropped 20% or if a stock you owned doubled. Answer a bunch of these and a formula spits back an assessment of how "risk tolerant" you are and recommends a portfolio that supposedly suits you.

Three months into the crazy '08 market, you probably already see the flaw in this thinking: You can't predict what you'd do in a downturn until you're in one.

No doubt you felt a lot more daring when the Dow was at 14,000 last fall than you feel now - and you might have picked a much different portfolio. You're not alone. Says Nofsinger: "The idea that you have a constant risk tolerance is just not an accurate view of how things work."

Moreover, your appetite for risk doesn't wax and wane solely with the market's ups and downs. It changes for all kinds of reasons.

"It can depend on your mood, the time of day, whether you had a fight with your spouse, even the weather," says UCLA's Subrahmanyam. He notes, for instance, that stocks typically spike prior to holidays like the Fourth of July when investors are happily anticipating their vacations.

The lesson: Research into investor psychology shows that you're likely to see the risk in today's stock market as greater than it really is, just as last fall you saw it as less than it really was. And postwar market history suggests that if you act on that emotional perception, you'll regret it later when stocks rebound and leave you behind.

What do you do? Instead of relying on your gut feel for risk and reward today, you'll be far better off focusing on your long-term financial goals, allocating your assets accordingly and sticking to your plan.

The model portfolios above are a beginning. But before you can build a strategy around goals, you need to spend some time figuring out what yours truly are - which is the second big thing you need to get right in this market.

The next story will show you how. To top of page

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