A couple of readers have mentioned that they’re nervous about the stock market’s recent volatility. I’ve read similar concerns on other blogs and financial news sites. People are worried that the stock market’s performance over the last month portends an impending bear market, and they don’t know what to do.
Reading these concerns reminded me of Why Smart People Make Big Money Mistakes, which I reviewed last week. In the book, the authors discuss panic selling as a common financial pitfall. When people suffer from loss aversion, short-term losses cause them to sell investments prematurely, which can lead to greater pain:
One of the most obvious and important areas in which loss aversion skews judgment is in investing. In the short term, being especially sensitive to losses contributes to the panic selling that accompanies stock market crashes. The Dow Jones Industrial Average tumbles (along with stock prices and mutual fund shares in general), and the pain of these losses makes many investors overreact: the injured want to stop the bleeding. The problem, of course, is that pulling your money out of the stock market on such a willy-nilly basis leaves you vulnerable to a different sort of pain — the pangs you’ll feel when stock prices rise while you’re licking your wounds.
But what can you do if being in the market makes you nervous? You don’t want to lose your money — what happens if the market continues to fall? If you feel trepidation about stocks, assess your risk tolerance. There are several online tools that can help you with this:
- Rutgers investment risk tolerance quiz
- MSN Money risk tolerance quiz (and an article on the subject)
- Kiplinger: Test your risk tolerance
If your risk tolerance is low, then the stock market may not be right for you. Perhaps you should consider less volatile investments until you’ve researched the market’s historic performance.
If you have a decent tolerance for risk and still feel nervous, pay less attention to market news. Again, Why Smart People Make Big Money Mistakes offers excellent advice:
Pay less attention to your investments. Horrors! How can we think such heresy. Don’t worry, we’re not advocating turning a totally blind eye to your hard-earned savings, mostly because nobody would listen: a recent American Stock Exchange study indicated that nearly 40 percent of young, middle-class investors check their investment returns once a week! And that’s simply too often. The more frequently you check your investments, the more you’ll notice — and feel the urge to react to — the ups and downs that are an inevitable part of the stock and bond markets. For most investors — frankly, for all investors who don’t trade professionally — a yearly review of your portfolio is frequent enough to make necessary adjustments in your allocation of assets.
One strategy for minimizing fears is to buy and hold low-cost stock market index funds. Reduce the effect of market fluctuations by making systematic regular investments. This is what I intend to do when I’ve eliminated my debt — I’ll schedule a regular monthly purchase of QQQQ (or similar index fund), automate the process, and forget about it.
In The Little Book of Common Sense Investing, John C. Bogle, the great pioneer of index funds, warns against attaching too much meaning to what he terms the “expectations market”, the guessing that investors — amateur and professional — make when trying to predict the market’s direction. When we begin to focus on the short-term noise, we’re speculating and not investing. Bogle writes:
There are bumps along the way in [investment returns]. Sometimes, as in the Great Depression of the early 1930s, these bumps are large. But we get over them. So, if you stand back from [a chart of stock market returns since 1900], the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.
The entire text of Common Sense Investing is a treatise on the virtues of index funds. Bogle states that “the case for the success of indexing in the past is compelling and unarguable”. He believes overall market returns may be lower in the coming decade, but that this actually makes index funds (with their low costs) more attractive, not less attractive.
If the road to investment success is filled with dangerous turns and and giant potholes, never forget that simple arithmetic can enable you to moderate those turns and avoid those potholes. So do your best to diversify to the nth degree; minimize your investment expenses; and focus your emotions where they cannot wreak the kind of havoc that most people experience in their investment programs. Rely on your own common sense. Emphasize all-stock-market index funds. Carefully consider your risk tolerance and the portion of your investments you allocate to equities. Then stay the course.
In other words: your best choice is to invest in low-cost index funds that mirror market performance, even during rough patches. If you are risk averse, then shift some of your portfolio to bond-market index funds. Maintain your investment strategy, no matter which way the market is moving.
Benjamin Graham once wrote: “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.” It’s not the short-term that matters; it’s the long-term that’s important.
Addendum: In the comments, Ogden points to recent commentary from Ben Stein on this subject. Also, Free Money Finance recently wrote about going against the flow. And here’s more on the subject from Andrew Tobias.