It's natural in this environment for investors to show reluctance toward stocks. Even the best money managers like to have cash available to take advantage of short-term market mispricings. But as difficult as it may seem in the short term, you should invest more as markets decline.

Warren Buffett sold out of PetroChina (NYSE:PTR) while everyone else was plowing money into Chinese equities. Why? Chinese equities have mounted astronomical gains over the years, and PetroChina reached a fair enough value for Buffett. He has been around long enough to know that when everyone else is excited, it's best to leave the party early. Excited investors can allow emotional tendencies to take the place of rational analysis.

Now's the right time to get excited
As markets decline, serious investors get excited. The S&P 500 index is down more than 12% over the past year. Amid all the poor investments, market declines lead to more attractive opportunities. And investing in declining markets, believe it or not, will yield fewer investing mistakes, because you're less likely to buy anything at its peak price.

Investors use research and analysis to find companies that will provide satisfactory rates of return while protecting principal. Anyone who allocates capital this way should welcome declining markets. If the Dow Jones were to suddenly fall to 10,000, I would be 100% invested; conversely, if the Dow were to jump to 15,000, I might only be 50% invested. Consider the following illustration:

Suppose you create a portfolio of 10 securities that have an aggregate intrinsic value of $100, but only cost you $50. This portfolio is trading at a 50% discount to your assessed intrinsic value -- a 100% rate of return over two or three years. Over the next month, market indices decline 15%; since your portfolio's particularly concentrated, it actually slips 30%. Your portfolio is now valued at $35 -- but its intrinsic value still remains at $100. Your portfolio is now trading at a greater discount to intrinsic value, thus providing a more compelling rate of return and an even better margin of safety.

As markets decline, sound businesses usually decline with them. As a result, if you can stomach a little volatility, your returns will improve, since you're buying in at even greater bargains.

The trick is to come up with an acceptable estimate of intrinsic value for each stock, and only buy securities that are undervalued to begin with. Such undervalued businesses can become even more valuable as their share prices decline -- provided the price drop is purely irrational.

Intrinsic value can change
Declining markets do a wonderful job of exposing sloppy, unsustainable business practices of companies that "were caught swimming naked when the tide went out," to paraphrase a popular Buffett metaphor.

Former mortgage highflier New Century Financial was forced to file for bankruptcy. Earlier in the year, rumors flew that Countrywide Financial was headed for permanent troubles, until the bailout purchase by Bank of America (NYSE:BAC) gave shareholders at least some part of their investment.

Last year, Beazer Homes (NYSE:BZH) appeared to be a bargain, with a book value of $28 versus a $12 stock price. Yet a quick look at its assets provided evidence that its intrinsic value had deteriorated alongside the stock price. At the time, most homebuilders like Hovnanian (NYSE:HOV), Centex (NYSE:CTX), and Pulte (NYSE:PHM) were also "cheap" based on price-to-book value. But after considering the possible land impairments and inventory charges they faced, further declines in their share prices seemed imminent.

When your investments decline, you need to be sure that intrinsic value has not been impaired as well. If it remains strong, then back up the truck.

Simple but not easy
Watching a continual market decline, day in and day out, wreaks havoc on investors. Get used it. If you plan on investing for a substantial period of time, you will experience recessions, bear markets, bubbles, and panics. And you will also make some bad decisions. But if you can ignore what the market does daily, and focus on what your companies do, you'll find it far simpler to ride out the declines relatively unscathed.

Further Foolishness:

Anand Chokkavelu updated this article, originally written by Sham Gad and published Feb. 8, 2008. Anand does not own shares in any companies mentioned. Bank of America is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.