Net Gains: Lessons From the Latest Panic

May 7, 2008 — -- On Jan. 22, panic was in the air.

For three weeks, stocks had been in free fall. The day before, while the U.S. market was closed, foreign stock markets plunged. Worry gripped investors.

The Dow Jones Industrial Average fell 128 points that day, capping off a nearly 10 percent decline since the beginning of the year. There appeared to be no limit to how far stock prices might fall.

How long would it be before stock prices lost another 10 percent, maybe even 20 percent? One day? One week? One month?

Many investors didn't want to stick around to find out.

Now, less than five months later, imagine you succumbed to the panic that day and dumped all your stock holdings in favor of a bank CD or money-market fund. What would have happened?

There's a good chance you'd be feeling some regret right now.

For a day or two, you would have felt good about your rush to safety and maybe even a little smug as the Dow fell even further in March, reaching its low point for the year — 11,740 on March 10.

Ultimately, however, what would have happened is by selling you would have locked in losses and missed out on a rebound. From Jan. 22 through Monday, the Dow rose 8.3 percent. In the meantime, a bank CD might have earned at best 1 percent during that same period.

Consider that lesson in why it's never wise to fall victim to market panic.

Sooner or later such a decision will come back to bite you. The only question is how long before you realize it.

Like nearly every other financial planner or investment adviser in America, on Jan. 22 I recommended investors resist rash decisions to sell during what certainly was a turbulent spell in the stock market.

"Sell out of panic, and there's a good chance you will regret it later on," I told an ABCNEWS.com reporter that day.

I had no idea at the time how long the market downturn would last or when a rebound might occur. At the time, I certainly thought there was good reason for investors to feel pessimistic given the state of the economy, including the depressed housing market and a credit market in near meltdown.

I would not have been surprised if stocks fell another 10 percent from the March low. I'm not even convinced the current rebound is going to last. And, of course, at the very moment I write about this recent rebound, stock prices are down for the second consecutive day, erasing some of the gains.

But this two-day spell underscores the truth that no one knows what's next. That's why you build a portfolio under the assumption we'll encounter periods like late January and early March. You construct it to withstand such spells and still capture the upside when it occurs, again without warning.

If sudden price declines were not an issue, then we would all be 100 percent invested in stocks rather than 80 percent, 60 percent or 40 percent. But we know a bear market could be around every corner, and we need to decide how much of a short-term loss we can withstand.

Money for the long term belongs in stocks, no matter the short-term outlook. Money for the short term belongs in cash and bonds, no matter how goods things look with stocks.

Figure out the right mix for you, and then stick with the plan — even when the next Jan. 22 occurs.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com