Avoid This Mistake or You'll Never Recover

Investors who sold their stocks before the worst of the financial crisis struck last fall seemed like utter geniuses when the bottom fell out of the market. Yet before those who sold can claim true victory, you have to ask them one question: Did they get back into stocks in time to pick up some big bargains, or are they still on the sidelines, watching the market go higher?

When times get tough, you'll always feel the temptation to run for the hills with your money by selling out of risky assets. Often, that strategy will pay off in the short run, as whatever situation inspired you to sell goes from bad to worse. But if you never regain confidence in the market even once stocks start to rebound, then your attempt to time the market will always turn out to have been a losing proposition.

How most investors goof
A recent study from Hewitt Associates describes exactly what's going on in greater detail. Hewitt, which manages 401(k) retirement accounts, recently said that investors in its plans sold more than $6 billion in stock investments during 2008, favoring safer low-growth alternatives like stable value funds. Those sales pushed the proportion of account balances invested in stocks from 67% at the end of 2007 to 53% as of June.

Those numbers aren't surprising, because we already know that many investors panic during large stock market drops. Yet the more important statement from Hewitt is that once investors decide to dump their stocks during a downturn, they rarely get around to buying them back once the market rebounds.

The second half of the story
Unfortunately, failing to get back into the stock market in time is potentially a much larger mistake than never having sold your stocks in the first place. Sure, it feels good to have avoided seeing your portfolio drop as far as it would have if you had held onto all your stocks. But after the market recovers, you could easily see yourself with a smaller net worth than if you had stuck with your original portfolio.

Take a simple example. Say that in response to all that bad news last August and September, you decided that things were going to get even worse. Although you didn't have good enough foresight to sell stocks at their record highs, you did manage to sell at the beginning of October, well before the big market drops in November and March. Here's what would have happened between then and now:

Source: Yahoo! Finance.

Selling back in October would have saved you from a world of hurt over the past year, preventing you from having to watch your investments cut in half or more in many cases. Yet if you stubbornly stayed out of the market as those stocks rebounded, then not only did you not profit from those big drops, but in some cases you even lost money compared with those who never touched their shares throughout the crisis.

Moreover, those missed opportunities could well be just the tip of the iceberg. If you permanently decide to lower your exposure to stocks, then the gains you miss out in the future could make these short-term returns look like small change.

It takes two to time
Protecting your portfolio from losses is one of the most important keys to being a successful investor. But if you decide that you're going to sell shares of a stock you like for the long term, you need to remember that selling is only the first part of a two-part process. You also need to figure out when you're going to buy back those shares.

As simple as that sounds, experience shows that it's anything but. It's actually much easier to accept the rises and falls of the market by holding onto the stocks you think are good long-term holdings through thick and thin. That will save you from a potentially much larger mistake from which your portfolio might never recover.