Are You Afraid of the Stock Market?

I saw a recent article where a large majority of individuals surveyed claimed that they had missed the stock market rally occured from the lows of Q1 2009.  I think for the most part this has to be not entirely true since a lot of cash did re-enter the market, but I also think it reflects the view that most people are skittish about stepping back in. And indeed, I know of people who, upon seeing their monthly statements decline month after month in 2008, withdrew all of their money from stock funds and placed them into money market funds or bank CDs.  Although they planned to re-invest, they have been gunshy so far and have missed out on substantial gains, and the concern is that their portfolio is not sufficiently insulated from inflation.  I had previously written about Avoiding Whiplash in this Market, and I think some of those lessons need to be revisited and augmented with additional points:

–Have an accurate time frame in mind — for a retirement portfolio, it makes a big difference if you plan to retire in 5 years, 20 years or 30 years.  If you are young and plan to continue to put money aside in your retirement plan for many years, my advice is to focus more on setting aside sufficient amounts each month rather than trying to fine tune the investment performance.  Most people end up with too small of a retirement because they underinvested.

–Avoid making buy/sell or asset allocation decisions when feeling panicked — most portfolios tend to lag when a bear market bottoms and turns around because of holding too much cash. As with most decisions, stopping to calm down and think things through rationally is helpful.

–Keep the emergency fund and investment fund separate — one of the reasons one of my friends panicked was that he was treating his money that was invested in the stock market as an emergency fund.  This is unwise as the emergency fund shoud be put aside for emergencies and not subject to market volatility. I keep my emergency fund in a mix of ING direct savings and a short-term high quality bond fund.  Some purists would say the bond fund is a bit risky, but the fund is larger than the recommended.

––Avoid listening to too much news – I find that the news (including blogs) tends to be very positive after the markets have run up and very negative after substantial declines.  Investment decisions should be the opposite.  While many people want to think they can outsmart the market, I’ve encountered very few who have on a continuous basis.

–Remember that down years are often followed by up years — Often when the market is down sharply in one calendar year, it recovers sharply the next (not always).  One of the reasons panic hurts a portfolio, is that people tend to respond emotionally.

shared at this week’s Carnival of Personal Finance