When Animals Attack!

Dear investor,

As surely as long, dark winters come to Scandinavia, each year a bear will claw its way through our stock market. And we will all sit bleary-eyed before a portfolio screen bleeding red with temporary but significant losses. Fear drives down stocks faster than greed drives them up. In the next downturn, you should expect a short, sharp, shocking decline that takes down your portfolio 15% to 20%.

Will you be prepared?

Will you know what do when the next Asian flu, Internet bubble, hedge-fund scandal, stagflationary crisis, terrorist attack, or unforeseen calamity sends equities low enough to slide beneath the lowest limbo stick?

Will you know what to do?

We do.

Don't know your past, don't know your future
History shows that the stock market gains ground two out of every three years. That suggests three things to us. First, you have to be able to suck it up when stocks fall. Second, the mathematics of transaction costs, capital gains taxes, and the market's tendency to rise make it very clear that investors who sell the least profit most. Third, you can make a fortune in down markets if you curtail spending and generate extra income to invest into stocks.

Indeed, when the market falls 10% or more -- as the Russell 2000 small-cap index has since the middle of May -- you're best served to add new money more aggressively than before. And what if the market keeps falling? Save more. Invest more.

Between 2000 and 2005, when the stock market went nowhere, the year 2002 will prove to have been the best year to buy stocks. During that year, the Russell 2000 fell more than 20%. The S&P 500 dropped nearly 25%. You didn't hear much about hot IPOs, sure-thing penny stocks, or the glorious telecom revolution in 2002. Stocks were getting crushed; investors were selling out of fear; the trend was ugly.

What a perfect time to buy!

Those gut-wrenching drops present the greatest of all buying opportunities. For some short-term proof, just take a look at the returns you could have earned investing in some well-known companies when the outlook was bleakest:

Those opportunities are amplified when you start researching smaller and smaller companies -- like Coventry Health Care.

To the contrary!
Of course, it can be very difficult to buy in the face of mounting paper losses, when the financial media is crying "Blood in the streets!" and your relatives who invest only in real estate are chuckling at you. After all, as humans, we take comfort in crowds. We love the safety and the thrill that comes from winning alongside everyone else ... believing when the crowd believes, backing off when the crowd shudders. But this is exactly the way to fail as an investor.

Instead, you should hunger for the temporary crisis that sends crowds into a conniption of hand-wringing, teeth-gnashing, and stock-selling. Remember, there are more than 100 years of market data showing that downturns are good for returns. Dr. Jeremy Siegel of the Wharton Business School has proved that in the darkest hours of the Great Depression, investors faced one of the greatest investment opportunities in history.

Stand up to a rampaging market
When the market falls, investors who can save and invest more have a better chance of becoming independently wealthy in time. That's why we're advising members of our Motley Fool Hidden Gems small-cap investing service to keep saving and keep adding to their positions this summer. After the incredible run that small caps had since 2003, many of our members were elated with their returns. We weren't as elated -- worried that there would be fewer small-cap bargains for us to recommend. But we're now pleased with the 10% decline, excited about the emergence of some new bargains, and even hopeful that the Russell 2000 might fall further.

That's because our goal at Hidden Gems is to help members save and invest in the market's very best small companies for the long term. If we can find a great company, why should we not be thrilled by an increasing discount to its price? As long-term owner-investors, we savor the possibilities.

If you'd like to learn more about our Hidden Gems service, see all of our formal recommendations, and enjoy it free for 30 days, click here. There is no obligation to subscribe.

For more articles in this series

• Plan for All Seasons: Introduction
• A Retirement Plan for All Seasons
• Forget It in July
• The Summer of Our Discontent
• Planning for the Unthinkable
• Terrorism and Market Preparation
• Disaster-Proof Your Prized Possessions

Amazon.com and Coventry are both Motley Fool Stock Advisor picks.

Neither Tom Gardner nor Tim Hanson owns shares of any company mentioned in this article. Fool co-founder Tom Gardner is the lead analyst of Motley Fool Hidden Gems . The Motley Fool has a disclosure policy.