Panic-Proof your Portfolio – Part 1

Last week the US stock market continued to gyrate. The catalysts came in the form of the usual suspects: housing; credit; financial companies collapsing; and overall angst over the direction of everything. It’s hard to hear this, but these are the times that can define your long term performance as an investor. It’s time to “Panic-Proof” your portfolio!

First of all, remember that if you are an investor of any kind, you have signed on for some tough times. Panic-proofing does not mean avoiding all losses, but it does mean taking specific actions to lessen the chance of loss. The most important thing is to remain calm and not to panic. As I have said many times, average investors do not underperform the indexes because the pros are better stock-pickers. The biggest problem that investors face is that they purchase and sell at precisely the wrong time, usually as a result of reacting to either fear or greed.

I have hauled out the results of the Dalbar survey “Quantitative Analysis of Investor Behavior” in previous articles to illustrate this point: from 1986-2005, the S&P 500 index returned 11.9%, while investors returned 3.9%. The reason is simple: many can be led astray by their emotions. You have probably been there yourself: when you see asset prices drop, you are tempted to sell, while when you see them rising, you feel confident and pile in. This is the clearest example of how average investors consistently sell low and buy high.

To prevent yourself from falling into the emotional “sell low and buy high” trap that is often exacerbated at the peaks and valleys of the economic cycle, I am going to repeat something that I know that I have said many times: you need a plan that incorporates your risk tolerance, including your time horizon for needing to access your money; your feelings about volatility (the ups and downs of the market); and your willingness to accept losses. Only after your goals and risk tolerance have been properly addressed can you successfully manage your money with a well-diversified portfolio.

Once you have the plan, you MUST periodically rebalance your accounts. Again, diversification does not shield you from losses, but it can mitigate the extreme movements of the market (both up and down). A well-diversified investment portfolio is better able to withstand whatever blows the economy delivers and can cushion you against unexpected market risks you can't control. Tomorrow we will talk about rotation decisions that you may want to consider as the economy bounces around the lows.