What You Know May Hurt Your Investments

(MoneyWatch)  Whenever the stock market goes south, I get questions like: "Larry, it is obvious that the economy is in trouble. Isn't it time to play it safe and get out of the market?" This question has a two-part answer.

First, as Bernard Baruch noted: "Something that everyone knows isn't worth knowing." In other words, if you know the economy is in trouble, surely the market does as well and that information is already built into prices. Thus, it is too late to benefit from that "insight."

Second, the risk to equity investors rises during a recession, which also causes the risk premium for investing in stocks to rise. That -- plus the drop in earnings that occurs during recessions -- are the reasons why prices have already fallen. To avoid the fall in prices you would have had to predict the recession and the bear market ahead of time -- something economists, market forecasters and money managers have a dismal track record of doing. What some investors fail to grasp are the following key points.

• Risk and expected return are related. If the risks are higher now, so is the expected return. Thus, those who sell during bear markets are selling when the expected return is high.
• If the current pessimistic outlook for the economy is fully reflected in prices, future returns will be high even if the pessimistic forecasts are accurate. If the forecast turns out to be too pessimistic, returns will be even higher. It is only if the future turns out to be even worse than expected will returns be below expectations.

When the bad news of the economy has you thinking about getting out of the market, ask yourself if you are acting on widely-known information. If so, it is already too late to act. (And, by the way, if you heard it from Jim Cramer it is most certainly too late.) Also ask yourself if you really want to sell when expected returns are significantly higher than when you bought in the first place.