On a recent radio show, I heard firsthand how fearful individual investors are these days. Remember: Scary markets are there to provide you opportunities. A little planning ahead can help you take advantage of the current, manic environment.
The guy next door nearly always gets his investing decisions wrong. No offense intended.
I say that because, unless you live next to a certain well-known geezer in Omaha, the odds are that your neighbors are, as you read this, falling victim to market-lagging, returns-killing mass psychology.
Worse yet, the odds are that you do, too.
Everybody does it ... wrong
As Peter Lynch explained (and much research confirms), most mom-and-pop investors buy in when markets are high, and get out when markets are low and falling. By buying when everyone else is, and selling when they're scared, they even manage to underperform their mutual funds' performance. The psychology is easy enough to understand. Take, for example, SodaStream International
Earlier this year, this hot stock advanced on continual growth, and those who sat out the early gains thinking, "It can't last," eventually succumbed to the pain of watching "everyone else get rich." Next, they compounded the error with bad sell decisions (as the SodaStream chart also shows).
Highfliers aren't the only stocks that fall victim to panic. When a boring Ford
Deja vu, again
I got several earfuls of neighborly fear when I recently did a call-in segment on Minnesota Public Radio's Midmorning. With the pain of the 2008 market collapse still fresh, and the recent roller-coaster ride stirring fears, many callers picked up the phone to let me know that they would never be back in the stock market.
Another, whose job loss and near foreclosure wiped out her retirement savings, swore she wouldn't buy stocks, but would invest instead in small, local businesses (which are riskier, less transparent in their financial reporting, and much, much less liquid).
Unfortunately for Mom and Pop, this fear and loathing of stocks isn't an isolated anecdote masquerading as a trend. According to a recent Morningstar article, the rush out of the market continues. Mutual fund outflows in July were nearly as bad as during the peak of the financial crisis in October 2008. I believe (as does Morningstar) that August's market fits will make things worse.
In other words, your neighbors are looking at the volatile markets and taking action. As usual, they're doing exactly the wrong thing and getting out of stocks at exactly the wrong time. In the years since the financial crisis, corporations have strengthened their balance sheets; they've cut back on expenses and right-sized their inventory. Hundreds of public companies are more efficient, more financially powerful, than ever before, and thanks to recent market panic, they look cheap by any standard.
How can you avoid your neighbors' mistakes and improve your returns?
One way is to do nothing. If you remove much of the decision-making from your investing, you remove most of your opportunity to make mistakes. That's why I (and The Motley Fool) have always advocated regular, automatic investing (into index funds, ETFs, mutual funds, or individual stocks) as a perfectly reasonable way to grow wealth for the long term. But I think you can do better than that.
Take the Dangerfield approach
Here's a simple lesson from Caddyshack. Rodney Dangerfield's Al Czervik answers his mobile phone, and finds his broker on the other end. "Buy! Buy! Buy!" he says. "What? They're all buying? Then Sell! Sell! Sell!"
The line is good for a laugh precisely because it sounds crazy. Deep down, everyone knows how difficult it is to do the opposite of what the crowd is doing, especially during manias and panics. But that's precisely what you must do if you want your best shot at beating your neighbors, and beating the market.
Five simple rules
Simple isn't the same as easy, so I follow a few rules to help make market panics work for me -- and to help make my process nimbler in these days of quick market reversals.
- Plan Foolishly. Your portfolio should reflect your individual financial realities. Are you living off your investments? Then you may not want to be in stocks at all. Got 30 years until retirement? Bonds are probably a bad bet.
- Reassess your risk tolerance. If you can't sleep at night following 10%, 20%, or even 40% downswings in individual stocks, then you shouldn't be buying them at all.
- Plan ahead. The middle of a market panic is no time to change your asset allocations. Taking a big bath on stocks in order to move the funds into "safer" assets locks in losses.
- Keep a cash cushion. I've long advised people to keep at least six months' worth of living expenses in cash in case the worst happens. In addition, stock investors should keep enough investing cash on hand to buy three or four positions so that they're ready to take advantage of market sell-offs.
- Keep a shopping list. Know what stocks you'd like to own and the prices you'd like to pay. Computer-driven drops can reverse in minutes. Your shopping list helps you move quickly enough to take advantage of the market's irrational fits.
Shopping list ideas
Need to seed your own shopping list? Here are a few stocks at the top of mine.
Air Products and Chemicals
For five more ideas, check out the free report "5 Stocks The Motley Fool Owns -- And You Should Too."