What the Market Meltdown Should Have Taught You

Last year's financial crisis reminded investors just how risky stock investing can be. Yet while the crisis gave many investors a strong education in how the financial markets work in times of panic, you need to be careful not to take the wrong lessons from your experiences during the bear market.

The first real bear
This bear market marks the first time that many investors have ever seen a truly broad-based bear market in stocks. Consider some previous experiences you've had with down markets:

  • The tech bust earlier this decade threw major market averages for a big loop, with the S&P 500 giving up half its value from March 2000 to October 2002. Technology stocks saw much larger declines. But dozens of stocks, such as SYSCO (NYSE: SYY  ) and Berkshire Hathaway (NYSE: BRK-A  ) , actually posted substantial gains during that bear market.
  • Before 2000, bad markets were short and sweet, with violent downward swings that quickly reversed themselves. These mini-crises gave the impression that all you had to do to beat down markets was to wait a short time to get all your money back.
  • Even after the 1987 stock market crash, it only took a couple of years for stocks to recover everything they'd lost. You have to go back to the 1970s to see stocks behave as badly as they have recently.

By comparison, this bear market has taken no prisoners. Few stocks bucked the trend, as nearly every sector eventually succumbed to losses. And even after a six-month rally amid signs of economic recovery, stocks are still off nearly 30% over the past two years. It seems unlikely they'll be returning to their 2007 highs anytime soon.

The wrong lessons
After suffering for such a long time, you've probably been tempted to do whatever it takes to keep anything like this from hurting your finances again. But many of those things would be exactly the wrong thing to do right now. Here are just a few:

1. Giving up on diversification.
Because the bear market punished stocks of all kinds, large and small, foreign and domestic, you might think that a diversified portfolio is overrated. But even though most markets suffered negative returns this time around, that's not always going to be the case. More often, various types of assets cycle in and out of favor. During 2000 and 2001, small-cap value stocks like Humana (NYSE: HUM  ) and Toll Brothers (NYSE: TOL  ) put in big positive performances. In the bull market that followed, many international stocks outperformed U.S. stocks, with some now-popular stocks putting in stellar performance.

Stock

Total Return, 1/1/2003 to 12/31/2007

Petroleo Brasileiro (NYSE: PBR  )

1,770%

Vale (NYSE: VALE  )

1,463%

Baidu (Nasdaq: BIDU  )

491%*

Source: Yahoo! Finance.
* Return from opening price on Aug. 5, 2005, when Baidu had its IPO.

Going forward, you shouldn't expect all stocks to rise and fall in lockstep. But because you can't predict which asset class will do best, owning some of everything ensures that you'll always have at least part of your portfolio in the best-performing group.

2. Cutting your risk tolerance.
The bear market sent many investors completely to the sidelines. Yet all that accomplished was a missed rally for many investors, which cost them the opportunity to make back much of their losses.

It's true that many people took on too much risk when stocks were doing well. In that light, cutting back a bit may make sense. But if you go too far, you'll not only give up the chance for future gains, but also put your entire financial future in jeopardy. Without the growth potential for riskier assets like stocks, most people don't stand a chance of reaching their financial goals.

3. Quitting on your savings.
One of the particularly painful experiences most people have gone through is seeing their 401(k), IRA, and other tax-favored accounts drop precipitously. The bear market brought criticism of 401(k) plans, as many workers now face the prospect of much-reduced resources when they retire. Similarly, those who used 529 college savings plans have also seen big losses.

With that kind of negative result, you might think it's not worth it to scrimp and save every penny you can. However, when your existing portfolio is at its lowest, new money makes the most difference.

2008 was a terrible experience for everyone. But don't let it ruin your entire investing life. By avoiding these three knee-jerk responses to the bear market, you'll ensure better results in the long run.

One attractive strategy seems to reduce risk, but it could actually cost you a fortune. Austin Edwards explains when you should sell stocks.

Fool contributor Dan Caplinger always tries to learn the right lessons. He and the Fool own shares of Berkshire Hathaway, which is a Motley Fool Stock Advisor recommendation. Baidu is a Rule Breakers pick. Berkshire Hathaway and SYSCO are Inside Value selections. Petroleo Brasileiro and SYSCO are Income Investor recommendations. The Fool's disclosure policy teaches you what you need to know.


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