Four Reasons Not to Overreact

Here are four reasons not to overreact to the recent drops in the stock market:

• Reason 1: Market timing is a losing strategy. You may be thinking you should sell now and get back into stocks later when the market "settles down" and the economy starts to recover. But this approach—called market timing—can lead to disappointing returns. In effect, it puts you at risk of selling low and buying high.

• Reason 2: Investors have been rewarded for taking risk. The steep and sudden stock market drops we've seen recently are certainly unsettling and may have done serious damage to your portfolio. But this very risk is why, over the long term, stocks have outperformed bonds or cash investments.

• Reason 3: Playing it "safe" can lead to a shortfall. Remember, your investments will need to outpace inflation over time, otherwise you'll lose purchasing power. Historically, it's been stocks that have helped investors compensate for inflation by delivering higher average annual returns than cash investments or bonds.

• Reason 4: Emotional decisions often lead to regrets. "Generally speaking, it tends to be a very bad idea to make emotional decisions in times that are already emotionally charged," he said. "If the market had a bad day yesterday and you come in today and sell, that doesn't make up for yesterday's losses. Actually, what you're doing is just capturing your losses."

I have to admit that even for a long-term investor (20 years or so before I need the money I have in the market) the recent stock market ups and downs (mostly downs unfortunately) have been difficult to bear. But I've kept as calm as possible, remain committed to investing (my 401k is still buying every month), and try to remind myself of the long-term goal. If I could, I'd probably turn off the TV and screen the internet to eliminate all the bad financial news, but then again, I'm a money blogger. Just seems like that solution wouldn't work for me. ;-)

A few things I have thought about during this recent downturn:

1. I need to review my asset allocation and put more into bonds/cash. I probably have 10% invested in them now -- a bit too aggressive even for someone with 20 years to go and who’s willing to take a lot of risk.

2. We're all in this together. I have a decent amount in international stocks, but they've been beaten down just like US stocks. When something as big as the mortgage crisis happens, it's going to take down everything.

3. What alternative investments are there to stocks? Maybe starting a business or investing (part ownership) in local businesses?

4. What's safe in a true market meltdown? Let's say the worst had happened and the market totally crashed -- what would be a safe place to keep your money? What would hold its value in these times? Cash? Gold? Something else?

Comments

[Richard]

Lesson #1 from when I was in my 20's signing up for my 401K seems to have been forgotten by most people these days. What lesson is that? When the market is low you can buy MORE than you could otherwise. This is the best time to be investing money into companies that normally would cost a pretty penny to get into. Since you can buy more than normally possible when the market recovers your portfolio of investments (401K or whatever) will be worth substantially more than normal.

It's shares... not a bank account. The more you have the more reward you can reap later when the market recovers.

It's still the same ole buy low and sell high mentality. So don't let the market get you down... this is the best time to invest. Though do keep in mind where you are at in life versus retirement and invest at a risk level that will allow you to still meet your goals.

[Tim]

It cracks me up when you hear advice such as "I'm buying now when stocks are on sale". Well, that's fine and dandy, but did you sell when stocks were too pricy? I doubt it. Buy and Hold is a losing strategy. Always has been. Take out the stock market's "bubble" returns from the 80's-90's and the average annual returns aren't so great.

[Anom]

I think a lot of people have this non-reality based faith that the market can perpetually grow.

"So where do some reasonable assumptions lead us? Let's say that GDP grows at an average 5% a year--3% real growth, which is pretty darn good, plus 2% inflation. If GDP grows at 5%, and you don't have some help from interest rates, the aggregate value of equities is not going to grow a whole lot more. Yes, you can add on a bit of return from dividends. But with stocks selling where they are today, the importance of dividends to total return is way down from what it used to be. Nor can investors expect to score because companies are busy boosting their per-share earnings by buying in their stock. The offset here is that the companies are just about as busy issuing new stock, both through primary offerings and those ever present stock options.

So I come back to my postulation of 5% growth in GDP and remind you that it is a limiting factor in the returns you're going to get: You cannot expect to forever realize a 12% annual increase--much less 22%--in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.

Now, maybe you'd like to argue a different case. Fair enough. But give me your assumptions. If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, "Well, that's because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level." Or you've got to rearrange these key variables in some other manner. The Tinker Bell approach--clap if you believe--just won't cut it. "

[Donny Gamble]

I don't think people should overreact at all and should look at this situation as a buying opportunity. Stocks are way below wholesale value and people should start getting back into the market slowly. Stocks are at levels where people think that every company in the world is going to go bankrupt.

[Anom]

Oh, and also... for all of you who blasted the 3% returns that were in that 401k article:

"Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more. "

Just some interesting thoughts.

[Prosperity Junky]

FMF - to your #3 and #4

I like the idea of local businesses but the easier answer is real estate. Real estate (you control it) verus stocks (they control it). You sited your reasons for not getting into it but I feel much better about my real estate than I do about my stock market investments right now. Granted, I have investments in one of the better markets right now, Texas. If the stock market completely crashed and your stocks went to 0 there would still be value in tanglible real estate. Doesn't that out way the headaches of a tenant?

[Trask]

Wow! You are finally starting to think FMF. Finally.

[Lacey]

This was a great post! I really enjoyed what you had to say! Reason #4 really struck a cord with me... I am really studying emotions and finances. It is amazing how much of our spending is emotional.

Again, Great post! Thanks!

[JACK]

My goodness, there's some chicken little's here. Yes, of course it is true that it's a bit of a misnomer to say "stocks are cheap" right now, as if they couldn't get cheaper. But it is also a mistake to forget that there are real assets underneath everything. I'm not saying go buy up stocks that are worth 1 dollar because they are worth 1 dollar. But there does exist the chance that the market is undervaluing real assets and one could acquire real assets quite cheaply this way.

And nobody's strategy is buy and hold. Everyone's strategy is buy-hold-sell. We just disagree on how long to hold because we disagree on what ultimately determines market value of a stock associated with a tangible business.

And FMF's final point is dead on: where would you turn besides the stock market? a business of your own or real estate are the only real answers and it's not like those are guaranteed to give you real returns either.

For my part, I've reduced my buy into the market. Not because I'm trying to time it (although a bit -- I'm confident it is still going lower) but because I realized I want a larger cash safety net than I currently have.

[Pop]

I've been in cash and short positions for the last 18 months- some of my accounts are up 100% over that period of time. I rode the market all the way down between 2001-03, never again. The "experts" who tell you all to do nothing are the ones out selling like mad.

[F]

@FMF: first you say it wouldn't be wise to sell your stocks now that the market is down, then you are contemplating alternative investments? Your resistance is crumbling, my friend. ;-) (Perfectably understandable given that your life savings are out there). Even though we might be in for another 1-2 years of decline (looking at historical performance DJI), I am not selling my stocks. Because one day fat times will arrive again and the surviving companies will see their stock price soar. It's a sure win, as long as you don't bet on weak or average companies (recession = wave of bankruptcies). My own plan is to hold the few stocks I have (25%) and gradually invest the remaining 75% cash on solid companies (i.e. every 6 months as the markets continue to decline). I realize I could probably make even more money in the long run by going temporarily short on the market, but I don't want to speculate with my savings.

@Anom: I love your remark about the 5% GDP growth vs 12% for stocks. Has anyone an intelligent answer to this?

[FMF]

All --

For those of you suggesting/thinking that I'm selling all my stocks, I'm not. The questions I'm asking about where else to invest are with the cash I have now (which was pretty sizeable because I was going to buy a house.) I'm thinking through what I should do with that amount and I'm NOT selling all my stocks at this point.

[kitty]

FMF - you may look into AA and AAA company bonds or municipal bonds. They are down now because of the credit crisis, and yield to maturity on some of them is in double digits. Last week municipal bonds were on sale as well. This changed a bit this week, but I did manage to buy a little of AAA rated NY State nunicipal bond a couple of days ago with tax-free YTM of 5.38% - 10 years remaining on this one, but the resale value is likely to go up as long as interest rates are going down. I'll probably hold to maturity anyway. The yields came down a bit, but you can still take a look. If you invest in company bonds investigate the company's ability to repay, obviously.

An advantage of individual bonds vs bond funds is that with bonds you have an option of holding to maturity whereas with bond funds, you entirely depend on resale value and this will drop as soon as the interest rates start going up. Also you have no control which bonds are in there. Of course, you can sell before that.

I am not selling stocks. The time to sell was last December and unfortunately I missed it. I will buy selected stocks here and there. I may move some of the fixed income portion of my portfolio into stocks as well in the next few months since I think we may be close to the bottom. At least Buffett seems to think there are bargains out there and as he was right in the past - in 1979 when he was buying, I believe in 1990 (I could be mistaken here), in 1999 when he warned about not staying after midnight at the ball, and in 2004 he told he cannot find any value in the market. Sure he may be wrong short-term, maybe even for a couple years or so, but I think he is right long-term.

I have about 125K in cash/CDs. I plan to put extra money from my salary - 2K-3K a month - into cash but as my CDs mature I'll look for some opportunities. I moved some part of my stable income 401K money into good-quality bond mutual fund last week, and plan to move a little bit of it in stocks as well - a little at a time, and still keeping nice chunk in stable value. Also, the part I moved to bonds I am ready to move to stocks as soon as it looks like interest rates may go up.

[Joan Ferreira]

I feel that it is wise to sell now, because the market is going down more and time it to buy once it starts coming back up. There is no need to ride the rollercoaster if you can just get the uphill and be better off.

What worries me is the discipline that you would need to have to make sure you can buy and sell at your planned times. Am not trying to be emotional but at my early age I just lost 20% of my investment, this is just unacceptable (meanwhile my HSBC accout is up at a flat 3%).

I think I am going to sell after december (the market always goes up during those month) and buy back late summer.

Any thoughts?

[F]

@Joan: since the trend is down the seller is likely to be proven right. However, determining the turning point is, in my experience, possible only years after the fact. I remember myself thinking in March 2004 (1 year into the new bull market; I was still a student) that the true market bottom was probably yet to come. Good luck in spotting the market turn. (Chances are your repurchase price might be much higher than your sale price... which reminds me that humans are inclined to sell low and buy high.)