Panic? Why?

When people panic the natural response is to seek shelter or flee the danger.

But, when it comes to the markets this doesn’t work. Why? Because everything is based on the economy … and nobody can escape the economy. In modern economies, there is no place to run since you can not escape the overall effect from the economy … either your job is affected, your income is affected, your purchasing power is affected, everything is affected regardless of where you invest locally. Diversification helps; however global events have global effects too.

Thus, there’s no point to panic. Those who panic have not adequately designed their portfolio for such inevitable occurrences.

It’s like being in the middle of an earthquake when it happens. You can’t escape it. You may think about going someplace where earthquakes rarely happen (rarely, because they happen all over), however effects of earthquakes are felt even though the earthquake itself was not. Effects like disruptions in services, transportation, etc.

Markets are global and are a bit different from my earthquake metaphor, which are local.

One may go where shocks are rarely felt in the investing world with short-term bonds and cash (or run to what appears to be going up at the moment … like gold in the late 2000′s). However, these tools have the long run effect of reducing potential returns. Solution? For the long run? Diversification and prudent asset allocation decisions that you can stick with regardless of how scary the news may be. A diligent rebalancing strategy and discipline also help.

How about jumping out when markets go bad and back in when markets are good again? Well, the trick is to know when a bad market starts and when a good market ends. Studies consistently show that more often than not, people end up losing money by trying to time these events. Remember, with such a strategy it takes two correct decisions to be right … when to get out; when to get back in.

Guess what, a prudent allocation 1) based on a correct match to your risk capacity and tolerance, and 2) based on proper diversification that includes buffering asset classes such as cash and short-term bonds (wikipedia, investopedia), doesn’t need to be changed … it you simply “stand still” the market events pulling prices down eventually reverse and prices go back up. This ”down and back up again” effect has been seen time and time again in the markets. Thus … a prudent strategy would be to invest in asset class indexes to avoid the situation where individual company stock can “go to zero” value (think Enron, TWA, etc., etc.).

Key takeaway: A properly designed strategy has already considered panic (I call this “time in the simulator“). Thus, just stand still for the earthquake to pass. Don’t panic.

Solution:

1) Be honest with yourself about how much decline you feel you can tolerate. Why? Because those feelings are what you will experience when the time comes.

2) An honest risk assessment leads to an honest allocation.

3) Prudent diversification also helps so there are parts that go down less than other parts (in other words, shock absorbers such as short term bonds and cash).

4) Remember, what is happening in the market is NOT the same as what is happening in your portfolio IF you have followed the above three steps. Yes, portfolio values may decline, but not as much as any given market because you also have exposure to other markets as well.

PS. I post this during a time when there is NO panic. Come back and read it during a time when there IS panic. What’s the difference? Simply your emotions pinging the part of your brain that is also associated with the “flight response” which in the investing world is “flight to quality” or “flight to safety.”

PPS. Declines and their definitions:  Market declines in general to 5% are considered “noise,” 5 to 10% are called “dips,” and your emotions may be getting the best of you over noise and dips … (10 -15% are considered “moderate corrections,”  15-20% are “severe corrections,” and over 20% is called a “bear market”). Bull and Bear Markets are defined as general market trends either up or down. Funny, nobody gets concerned when things seem to be going well.

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