Be centered, be still

Yesterday the Dow Jones Industrial Average closed at 11,740.15. This close is down almost 18.5% from the close on October 5th, 2007. The S&P 500 is also down over 18% in the same period. The Nasdaq is down almost 22%.

During storms of this magnitude, the tendency is to want to run and hide. Investors bail out of sectors that are being hardest hit and seek refuge in sectors that seem more defensive. When they realize that those sectors are being dragged down too, they bail out of stocks entirely and seek refuge in Treasuries, cash, or other perceived havens from the tempest.

As we have said in previous months (for example, in this post and in this post), research has demonstrated that investors often make their most costly mistakes during and after downturns such as the one the markets are currently experiencing. Jumping off of your ship in the middle of a hurricane, or even worse as it is nearing its end, is generally the worst time to do so.

Furthermore, in the face of a determined down market, there is no place to hide. The most solid companies with intact earnings whose prices are not pulled down by the initial selling seem like safe places to take refuge, but as the selling worsens and big institutions need to raise cash to meet redemptions they will hit those issues that have held up best. Those holdouts get pulled down with everything else as the storm passes through everywhere before it finally blows itself out.

Notice that the research says that investors make the most mistakes not only during but also after major market downturns. By bailing out at the worst possible time, investors also tend to remain out during the sometimes rapid upward moves that take place when the market turns. This often occurs before the consensus has even realized that the worst is over. The major upward moves in the stock market in March 2003 and later months are a good example, coming as they did only a few months after the absolute bottom of the longest bear market since WWII.

Our counsel during market storms of this nature is to remain "centered," remain still. Rushing around and making major portfolio changes during these events is almost always the wrong response. We stay alert to the unfolding developments, and if there is an investment that becomes attractive, we may move into it in very small "nibbles" rather than in a sweeping rush.

One of the most important characteristics for long-term success in investing is a consistent investment discipline that is founded on solid principles and convictions. If you allow temporary storms to blow you off of your principles, you will become like the majority of the investing public, whose process is generally to chase whatever is working lately. In the long run, that method has proven to be very unreliable.

For later posts on this same subject, see also:

• "Be centered, be still . . . revisited" 10/01/2008.
  

• "Be centered, be still -- 2011" 03/17/2011.