How to Panic Well

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A quick search for the word "panic" on one of my favorite financial news sites turns up almost 700 hits, many of them recent. "Avoid the Panic Room," "Panic in the Crude Pits," and "Positioning Yourself in the Current Market Panic" are just three of many recent articles that ran on this particular site. Search engines confirm that "panic" is a consistent theme across the major financial media at the moment, with thousands of recent hits.

Now, personally I'm inclined to think that Rule No. 1 of long-term investing is "don't panic, ever." As I've written in the past, following the herd -- especially when it panics and stampedes -- can lead to big losses during times of market turbulence that aren't directly related to your investments' fundamentals.

But some will insist on panicking anyway. Loss aversion -- the idea that people feel the pain of losses much more acutely than they feel the joy of equivalent gains -- is a well-demonstrated psychological principle, and it drives people to sell otherwise good investments and head for the hills when the market stumbles. If you're one of those people who feels loss aversion strongly, and you're not interested in working to overcome your impulse to panic and sell at the worst possible time, then read on. After all, if you're going to panic, you might as well do it right.

How to panic properly
As I see it, the three keys to proper investment panic are these:

• Time your panic carefully. There's an old Wall Street saying: If you're going to panic, panic early. Like a lot of Wall Street sayings, it's often nonsense. If you had panicked and sold Amazon (NYSE: AMZN) early on in the summer of 2000, during the first downward leg of the bear market, you might have lost some money -- but you still would have received about $50 a share. It wasn't until April of this year that the stock got solidly back above that level. If, on the other hand, you had held on until right after the 9/11 attacks, you could have sold for $7 a share. Now that's a satisfying panic sale.
• Lose a lot of money. I'm not talking about 5% here, I'm talking about a nice big loss -- the kind you would have gotten with Amazon, or the one you could have had by buying General Motors (NYSE: GM) at $35 in the summer of 2005 and then selling at $18 six months later, right before the turnaround plan (the one management had been talking about for months) started to bear fruit.
• Get a good story out of it. Selling Akamai (Nasdaq: AKAM) for $32 on its current dip, driven by fears about rising competitor Limelight (Nasdaq: LLNW), isn't much of a story -- that's just business. Selling Akamai (along with almost everyone else) at $0.90 after its founder died during the 9/11 attacks, only to watch it recover? Now that's a story.

How not to panic
If the above doesn't sound like much fun, you could always consider not panicking. I personally recommend this approach. Here's how not to panic:

• Remember that you're wired to worry. Downward swings in the market seem scary because of our natural tendency toward loss aversion -- and because they usually happen much more quickly than upward swings. The market may spend a year going up 25%, only to go down 10% in four or five days. Remember that that's just how the market works.
• Focus on fundamentals, not day-to-day prices. If you're an investor, not a trader, there's no need to sweat normal price movements. The question isn't whether your stock is up today, it's whether it's up over a year or two -- and more importantly, whether the reasons that drove you to buy it in the first place are still valid. If the management remains sound, the price still seems cheap in light of fundamentals, and the business outlook still seems bright, why sell?
• Take a vacation from market news. If you're not actively looking to make new investments (in which case it's a good time to be hunting for bargains), and the stress of the current market action is driving you nuts, turn off the news! Leave The Wall Street Journal unread. Resolve to ignore it, at least for a week or two. Remember that you haven't actually lost money if you haven't sold, and remember that markets have always recovered from dips and corrections.

The upshot is this: If the fundamentals of your investments remain sound, don't sweat Mr. Market's gyrations. Turn off your computer, take a deep breath, and go for a walk. Everything will still be there when you get back. And whatever you do, don't panic!

Akamai is a Motley Fool Rule Breakers recommendation. For investing tips about the most innovative companies in business, take advantage of a free 30-day trial and see everything Rule Breakers has to offer. Amazon is a Stock Advisor pick.

Fool contributor John Rosevear does not own any of the stocks mentioned above. The Motley Fool's disclosure policy never panics, but it does get a little twitchy from time to time.