Stock Investing Tips to Combat Fear

“Don’t try to buy bottoms and sell tops, it cannot be done except by liars.” – Bernard Baruch

Stock investing is not easy, but don’t try to make it more complicated than it has to be. With stocks at 5-year highs, I thought it would make sense to visit a question I have gotten a lot over the years. Is it time to sell my stocks?

This is one of the two questions I get most often from curious investors (the other being where do I invest my cash savings with 0% interest rates). The fiscal cliff sounds scary, should I sell all of my stocks? The U.S. debt was downgraded, should we get out of stocks? Europe is a mess, what should I do? Where do you think the stock market is going before the end of the year?

My simple answer to these questions is taken from a reply by J.P. Morgan (the man the bank is named after) when he was asked about the direction of the stock market.

“The one thing we can say for certain is that it will fluctuate.”

And of course he is right. One of the best pieces of advice I have received about the stock market in my career is that it’s not necessarily the news itself that matters, but how the market reacts to the news. And since the stock market is a collection of investors with far-ranging motives and emotions, the reaction is not always what we anticipate.

No one knows where the stock markets are headed in the short or even intermediate term. Warren Buffett himself states,

“I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now.”

If someone tells you they do, they are overconfident or lying.

Going into 2008 many market prognosticators were estimating that stock markets would reach their all-time peak. Instead the S&P 500 dropped 37% that year. At the beginning of 2009 when everyone thought the world was going to end and people were predicting the S&P 500 would drop to 300 (after already being cut in half), stocks rallied and the S&P ended the year up almost 27%.

That’s after being down almost 20% in the first 2 months of the year. The S&P 500 gained 135% from March 2009 through January 2013. This was during one of the worst economic recoveries in the post-World War II era. This is the exact same amount that it gained in the 1996 to 2000 time frame which many consider to be one of the greatest bull markets ever.

That doesn’t mean you can’t do something to take advantage of the movements of the market (remember stocks will be continue to be volatile). My first recommendation for those of you who are scared of the current investment environment would be to lower your stock allocation. Not to zero, but you can take it down a notch.

If you currently have a 70/30 stock to bond mix in your portfolio, give yourself some leeway and allow the weightings in each asset class to fluctuate. You could allow those weights to drift 5 to 10% away from their targets. If you are feeling nervous, sell some stocks and buy some bonds (or leave it in cash) and make it a 60/40 portfolio. That way you take some profits in stocks but don’t get out altogether and potentially miss a rally.

Or if you are feeling like taking on more risk, increase your weighting in stocks to 75% and lower bonds to 25%. You would still be close to your target asset allocation but you’ve tactically allowed your stocks to have a higher weight to increase risk.

If stocks take off, you can lock in some gains by rebalancing back to 70/30. If stocks fall and bonds rise then you will be closer to you target allocation again without having to make any further changes.

Another option would be to stick to the 70/30 allocation but increase the frequency with which you rebalance to those amounts. Most investors are set if they rebalance once or twice a year to their target weights.

If you are nervous at the moment because stocks (or bonds) have increased in value and want to book some gains, rebalance once a quarter or even once a month. This allows you lock in gains quicker and make more purchases of the laggards in your account (hence the phrase buy low, sell high).*

*Make sure this is done in a tax-advantaged account like a 401(k) or IRA to avoid paying short-term capital gain taxes. If making these moves in a taxable account, just change the amount you put into each asset class each time you make a contribution or rebalance.

Trying to time the market requires being right twice. You have to get out of the market by selling at the right time and you have to eventually get back in at the right point. Psychologically it will be nearly impossible to get both of these decisions right. Most humans have a negativity bias meaning that we perceive negative news to have a bigger impact than positive news.

That’s why studies have shown that the pain we receive from losing is much greater than the joy we receive from winning. And the recency bias means that we put way too much weight on what has been going on in the short term. We extrapolate that view going forward. The market has been going up lately so you feel great or the market has been getting killed lately so you feel terrible about it.

Getting back into the market after making a sale towards the most recent top is probably harder to do because it never feels good to buy when stocks are going down. We all listened to countless stories when the market was getting crushed in late 2008 and early 2009 of investors patting themselves on the back because they sold most of their stock exposure in late 2007 and early 2008.

But how many of those investors also had the courage to put their money back to work after the stock market had fallen over 50% from its peak?

You don’t hear too many of those stories because it feels safe to be in cash and bonds when the world is falling apart around you. However, if you are making big, tactical decisions with your investments you need to be buying at that point. Invest when there’s blood in the streets, the old saying goes.

It’s hard to make that leap of faith when our behavioral nature is one in which we are more worried about losses than wins. Stock investing can be very counterintuitive. That’s why it makes more sense to rebalance or decrease your risk by increasing your bond or cash allocation if you must make a change and are nervous about the stock market.

The other option is to just stay put and stick to your original investment plan. Back to Warren Buffett again who said,

“Lethargy, bordering on sloth, should remain the cornerstone of an investment style.”

Buffett has talked quite a bit over the years about how taking action for no reason can be harmful to investors.   It’s OK to just stand pat and not make too many moves if you don’t have to. Sometimes the best move we can make with our investments is to let them be and do nothing at all.  Famed depression-era investor Jesse Livermore stated,

“It was never my thinking that made me money, but my sitting tight.”

If you need to ask the question about getting out of stocks every time they move up or run into an event that makes investors nervous maybe you should re-think the allocation of your assets that you have in stocks. You can’t expect to just take part in the upside of stocks and miss out on all of the losses if you are a long-term investor.

Unfortunately, markets don’t price in risk that way. Stocks are a risky asset because they can and will sell off from time to time. You have to take the good with the bad.

The moral of the story is that stock investing can be difficult but don’t let your emotions make it harder than it already is. You will sleep much more soundly at night knowing you have an investment plan in advance that you will stick to it through thick and thin. That’s not the sexy thing to talk about at the cocktail party but by having a system in place you will know what to do no matter what the current market conditions.