Do This and You'll Never Panic Again

Successful investing takes a great deal of courage. If you don't have the fortitude and discipline to stick with the investment plan you establish, then you're almost certain to fail. That's why it's essential for your investment plan to take into account how you'll actually respond in tough times.

Get real
In theory, setting up an investment plan is incredibly simple. You can find plenty of rules of thumb about how various investors should set up a portfolio, including simple asset allocation models that have you invest aggressively when you're young and gradually scale back to more conservative investments when you're older.

In addition, when it comes to choosing individual stocks, you have a range of different philosophies you can follow. From focusing on fast-growing up-and-comers in innovative industries to sticking with tried-and-true, mature companies in well-established sectors, you can sift through thousands of stocks to find the ones that seem to fit best in your portfolio.

But when a crisis hits, reality comes crashing in -- and most of that theory flies right out the window. You need to make sure your plan can handle the truth.

Making mistakes even when you know better
Early last year, stock investors went through one of the most confidence-shaking periods in market history. Many people looked back at the market meltdown from the previous fall and assumed that they'd already seen the worst of the downturn. Yet after a brief push upward to start 2009, stocks went down to hit even lower levels, landing a death blow to what little remained of investors' hope for their investments.

I heard from many people who said that they'd decided that they'd had enough and were getting out. By itself, that didn't surprise me. What did surprise me, though, was how many of them said that they knew it was the worst thing they could do -- but that they were going to do it anyway.

As it turned out, they were completely right in their self-criticism. But the biggest mistake they made wasn't in panic-selling at the bottom. Rather, it was in the investing decisions that put them in that situation in the first place.

Know yourself
When you buy a stock, it's easy to get caught up in everything that could go right -- how much its price might rise, or how well its business might perform. Few people think about the potential downsides of an investment, and even if they do, it's usually not something they linger on.

But knowing how you'll respond when things go wrong is critical to your investing success. If you can't stand the thought of seeing your portfolio drop 20%, for instance, then you shouldn't have a lot of money in stocks -- regardless of what your theoretical asset allocation ought to be. And if you can't afford to see an individual stock holding drop that much, then you probably shouldn't own any individual stocks at all -- because your propensity to panic will cost you some big wins.

Just think of all the situations, both recently and in the more distant past, when stocks have bounced back against all odds. Over the past year, you've seen casino stocks like Las Vegas Sands (NYSE:LVS) and banks like Bank of America (NYSE:BAC) emerge from the ashes of the meltdown to soar. And take a look at these past examples:

Source: Yahoo! Finance.

No matter what stock you buy, you're going to face a crisis of confidence at some point when it drops. If you don't have the strength of will to stick with your convictions about your investments, then you'll sell low. And quite often, after the crisis has passed, you'll watch from the sidelines and miss out not only on eliminating your losses but on some huge gains as well.

Don't panic
Avoiding big mistakes is much more important in the long run than eking out every last bit of return by notching up your portfolio risk. That's why knowing how you'll react in stressful situations is crucial information to have. If you know where your breaking point is, you can keep well clear of it. That will put you in a far better position to capitalize on whatever opportunities the market gives you.