Smart Investing in a Market Panic

Sept. 23, 2008 — -- Allow me to introduce you to Mr. Panicked.

He went on a wild Wall Street ride last week, worrying himself sick over his portfolio. He heard those smarty pants financial advisers on television and radio urge small investors to avoid rash investment decisions.

They talked about the dangers of selling low and buying high and locking in losses. But what did they know? If they're so smart, they'd have jumped out of the market last year, never mind last week.

How do you feel about the government's bailout plans? Tell ABC News

They all said the same thing.

And Mr. Panicked was right about that last statement. Last week, I sounded like everyone else. I joined the chorus of financial writers and advisers warning small investors to resist panic and the urge to liquidate their portfolios in favor of all cash.

Unoriginal as my advice was, I stand by it. I stood by it when the Dow Jones industrial average dropped 504 points last Monday and then rose 141 on Tuesday, fell 449 on Wednesday and regained 778 on Thursday and Friday.

And I will offer the same, unoriginal advice the next time the stock market appears to be in a free fall.

That's not to say you should never makes changes to your portfolio, but rather that investment decisions are best made amid calm reflection.

Where I think financial writers and advisers like me fall short is explaining why it's unwise to panic when your portfolio has fallen tens of thousands of dollars in a short spell and appears almost certain to fall even more.

I'll use my friend Mr. Panicked and last week's events as an example of what might happen when you panic during market turmoil.

I'll assume my imaginary investor, Mr. Panicked, started last week with an even $100,000 in the Vanguard 500 Index fund, the widely held, low-cost fund that tracks the performance of the Standard & Poor's 500 Index.

He awoke that Monday morning to the news Lehman Brothers had collapsed and Bank of America had taken over the iconic bull of Wall Street, Merrill Lynch.

Avoid Panic in the Stock Market Crisis

Certain his entire life savings was at risk, Mr. Panicked logged on to his online account at midday and placed an order to sell his entire stake in the Vanguard 500. On the previous, the fund's closing share price was $115.79.

At the time of Mr. Panicked's sell order, the Standard & Poor's Index was down less than 2 percent. But because mutual funds can be bought and sold only at the closing price for a day, Mr. Panicked had to withstand further declines in the S&P 500 Index as the market went into a late-day tailspin.

His sale went through at the 4 p.m. price of $110.36 a share and he garnered $95,300 from the sale, down $4,700, or 4.7 percent.

On Tuesday, the market recovered slightly and the Vanguard 500 fund made a modest recovery, rising 1.7 percent. But Mr. Panicked still felt good about his sell decision as all the market talk centered on whether the insurance giant AIG would fall next.

By Wednesday, Mr. Panicked felt even more certain about his investing acumen as the market took another nose dive amid signs the credit market was tightening. The Vanguard 500 fund fell more than 4 percent that day with the fund's share price now at $106.98, nearly 8 percent less than where it started the week.

Starting Thursday, funny things began to happen in the stock market. It began to rise even as worries arose about the safety of money market funds and talk surfaced about a government agency to take over bad assets from banks.

On Thursday, the Vanguard 500 share price climbed 4.4 percent. Then on Friday, the stock market rally continued as big investors welcomed Treasury Secretary Henry Paulson's proposed bailout for banks.

By midday Friday, Mr. Panicked was overtaken by irrational exuberance. He decided it was time to jump back in the market by plowing his $95,300 in cash from his sale earlier in the week back into the Vanguard 500 fund.

But again, he had to buy at the day's closing price of $116.14, up 4 percent from the previous day. He could not buy as many fund shares as he first thought and he missed out on that day's gains as well as Thursdays.

Same Old Advice for Investors

For the week, Mr. Panicked started with $100,000 and ended with $95,300. Had he sat tight and listened to the same, boring advice he would have ended the week with $100,300 as the Vanguard 500 Index fund posted a .3 percent gain for the week.

Instead, Mr. Panicked locked in a $4,700 loss and missed out on a $300 gain.

Keep that in mind the next time you get tired of hearing the same old advice.

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.