How Not To Freak Out In A Market Downturn

stock panicThe stock market dropped by almost 50% from fall 2008 to spring 2009.

Investors panicked and pulled $82 billion from stock funds in the first few months of 2009 alone, a big mistake, as it turns out.

“An investor who freaked out and sold $100 in stock in early March 2009 would have earned about a dollar on her money market investments by the summer of 2013. The patient investors saw their stock investment climb to about $244,” writes Michael Finke, a personal finance professor at Texas Tech University, in a recent article on “Why Stock Investors Freak Out” in Research magazine.

It turns out that one of the best ways to protect your portfolio is to do nothing, and simply resist the urge to panic and sell. But that’s a skill many investors have a problem mastering.

Finke and other researchers at Texas Tech looked into what makes some investors panic and sell, and others stand their ground.

Here’s what they found:

Experience counts

“More experienced investors … do a better job of talking themselves down from the ledge,” said the Texas Tech team. While older and wealthier investors did make moderate changes to their portfolios during 2008, for the most part they stuck with their investment allocations. People with a history of investing, and taking investment risks, coped much better with market volatility in the 2008 Great Recession.

Seeing the glass half full

Investors who dwell on the negative, and focus on possible losses, are much more likely to sell out and run to cash in a market decline than more positively-oriented investors who focus on potential gains.  No one likes to lose money, but investors who stay on track during a pullback are able to shrug off losses more easily and move forward.

Taking the long-term view

Investors who have longer-term time horizons (for example, those who are investing for retirement) tend to stick more closely to their investment allocations and not make changes in turbulent markets. Analysts at Vanguard, who consider most of their account holders to be long-term investors, found that only a tiny 3% bailed out of stocks from 2007-2009.

A better safety net

Investors with an adequate emergency fund and solid health insurance (e.g. a good safety net) had an easier time taking portfolio volatility in stride, perhaps feeling more insulated from the consequences of a portfolio decline. This confirms what we have observed in our practice.  Clients with a stronger financial foundation are better able to weather the storms, invest confidently for long-term growth, and take advantage of opportunities.

Sharp as a tack

Here’s one that researchers didn’t really expect.  Clients with sharper mental abilities (especially where numbers were concerned) were more likely to stick to their investment strategy and less likely to move to cash in a market downturn. In contrast, those whose abilities were starting to decline had more difficulty handling market turbulence, possibly because they found it harder to get the negative emotional reactions of fear and panic under their rational control.

Talking it out

The researchers found that talking with someone else, especially someone trained to approach investment decisions from a rational angle – like an investment advisor – could help investors shoulder the emotional pressures of a bear market better. In fact, the Texas Tech team found that “one of the strongest predictors of maintaining one’s portfolio allocation was using a financial advisor. Even when (researchers) controlled for wealth and investment experience, the use of an advisor increased the likelihood of staying the course by 50%.”

A written financial plan

Having a written financial or investment plan did wonders in keeping investors true to their long-term goals and investment strategy. Researchers said clients with a written plan were “twice as likely to avoid the equity market freak-out” and stay on track.

The bottom line

“All stock investors are going to lose money,” says Professor Finke.  But “pulling out of stocks at the wrong time can erode portfolio performance and get in the way of reaching long-run goals.”

Investors can’t avoid down markets.  But how they choose to react to market declines can determine whether they make it to the ultimate finish line, or run out of steam half way through the race.

About Mari Adam

Mari Adam, Certified Financial Planner™ and President of Adam Financial Associates Inc, has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!

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