Smart investors keep their cool - Part 2

The stock market goes up and down. To make money you need to capture the upward movements. The only way to do that is to stay invested, especially in dicey times.

Don't kid yourself that you can flee stocks now and just slip back in at the last minute for a rebound. Volumes of research have proven that not even the pros can time the market with any consistent success. Focus instead on the fundamentals.

When the market plunges, so do price/earnings ratios. And the cheaper you can buy, the better your chances of making money in the future. As proof, consider the crash of October 1987 and its aftermath. Had you owned an S&P 500 index fund, you would have lost 23 per cent during that month, including a stunning 21 per cent on Black Monday.

Had you sold, you would have locked in that loss. But if you persevered, you would have got back to even in 20 months. And then you would have participated in the great Bull Run that followed, racking up an annualized 15 per cent return over the next 10 years.

Sticking to your guns was no easier 20 years ago than it is today, but the results suggest that the investors who will look the cleverest in a few years won't be the ones who are now jumping out of stocks and plunging into commodities.

No. 4 There's no such thing as risk tolerance.

Many questionnaires try to assess your appetite for risk. You might be asked what you'd do if the market dropped 20 per cent or if a stock you owned doubled. Answer a bunch of these and a formula spits back an assessment of how risk tolerant you are and recommends a portfolio that supposedly suits you.

Three months into the crazy '08 market, you probably already see the flaw in this thinking: You can't predict what you'd do in a downturn until you're in one.

No doubt you felt a lot more daring when the stock markets were at all-time highs last fall than you feel now-and you might have picked a much different portfolio. You're not alone. The idea that you have a constant risk tolerance is just not an accurate view of how things work with us. It is best to fill in the questionnaire when you are in a downturn, as this is your true risk tolerance.

The lesson

Research into investor psychology shows that you're likely to see the risk in today's stock market as greater than it really is, just as last fall you saw it as less than it really was. And postwar market history suggests that if you act on that emotional perception, you'll regret it when stocks rebound and leave you behind.

What do you do? Instead of relying on your gut feeling for risk and reward today, you are better off focusing on your long-term goals, allocating your assets accordingly, and sticking to your financial plan.

Source: Janice Revell, Money Magazine