Panic Is Not a Strategy—Nor Is Greed

If markets are good at one thing, it's reminding investors that stock prices don't simply go up, uninterrupted, forever. I have updated this report several times since it was initially published in 2008; and given recent market volatility, it made sense to do so again.

Markets do drop. Bear markets arrive. That's an unavoidable part of investing. What matters is how you respond. If you've built a portfolio that is directly tied to your time horizon and risk tolerance when markets are calm, then a surge in turbulence may not leave you shaken. Good planning, and discipline along the way, is like a pre-emptive dose of Dramamine—it can help neutralize some of the nausea before the turbulence hits.

Panic and greed

When it comes to panic, the most obvious example is trying to dump investments when the market is dropping. This is a great way to invert the old adage about buying low and selling high. Never before has information about the economy and markets been more readily available and disseminated; and never before has it been easier (and less expensive) to trade. As a result, our reaction mechanisms are heightened—but not necessarily to our advantage.

Greed can also lead us astray in a number of ways. First, there's the temptation to load up on aggressive higher-risk assets in the hope of a big payoff. But there is a dark side to an aggressive posture's potential higher returns: the risk taken in getting there. Aggressive portfolios' higher historical returns have had a much wider range of returns—that is, a higher standard deviation, with greater "drawdowns," or peak-to-trough declines, and volatility. And most importantly, those higher returns typically are generated through "stick-to-it-iveness," not lucky bets.

Then there's the temptation to try to "time" markets. It's enticing to try to catch the next big investment wave (up or down) and allocate assets accordingly. But there are very few time-tested tools for consistently making those decisions well.

It's also important to consider how the two impulses can work together, with yesterday's greed paving the way to tomorrow's panic. Investors may think they understand their risk tolerance—until they don't. There's a big difference between financial risk tolerance (the ability to financially withstand volatile markets) and emotional risk tolerance. The gap between the two is often quite wide and typically becomes evident in tumultuous market environments.

Relying on the rearview mirror

Too often, investors use a rearview mirror to make investing decisions, treating past performance as a guide to future results. I've known plenty of older, close-to-retirement investors who have stuck with their aggressive investment stances because they were accustomed to the thrill—with little fear about how a loss at the start of retirement might affect their savings. I've also known plenty of young investors who couldn't stomach the thought of any meaningful drawdown, despite having many decades in which to potentially recover and accumulate returns.

Many aggressive investors have learned the hard way that they had a lower tolerance for a big loss in the short term than they thought. And to maintain their aggressive allocations via rebalancing, they generally had to double down on the asset classes that generated those steep losses and shift away from the asset classes that had weathered the storm.

Conservative investors should heed the lesson, as well. A conservative portfolio's lower historical returns have come with significantly less-severe drawdowns and volatility. For some, the lower return is worth the sleep-at-night benefits. But the reality is that many investors want all of the upside when markets are performing well, but none of the downside when they are not. That is highly unrealistic.