Lessons From the Bear Market

(MoneyWatch)  Are you better than average in getting along with people? Are you a better-than-average driver? If you're like the average person, you probably answered yes to both questions. Studies have found that most people (even as much as 90 percent in some studies) answer positively to such questions. Obviously, 90 percent of the population can't be better than average at anything. And overestimating your skills in investing may end up being costly.

Overconfidence may be a healthy attribute in some ways. It makes us feel good about ourselves, creating a positive framework with which to get through life's experiences. Unfortunately, being overconfident of our investment skills leads to investment mistakes. This can include:

• Taking excessive risk because we believe we can forecast the direction of the markets.
• Concentrating risk into securities we believe will outperform.
• Betting on active managers because we think we can pick the few who will outperform their benchmark.

One thing some investors learned in the past months is that they overestimated their ability to withstand the stress created by bear markets, which caused them to have more risk than they should have.

When the bear market of 2008 and early 2009 arrived, those who overestimated their risk tolerance learned that bear markets can turn investors with 30-year horizons into investors with 30-day horizons. For many, the stress of losses and the noise of the financial media caused the abandonment of otherwise well-designed plans -- demonstrating the wisdom of Peter Lynch's warning: "Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn't the head, but the stomach that determines [your] fate."

One of my favorite expressions is "even smart people make mistakes." What differentiates them from fools is that they don't repeat their mistakes once they learn the error of their ways. If the bear market taught you that you had overestimated your willingness to take risk, you should adjust your equity allocation. Don't make the gambler's mistake of "playing until I get even." Also, don't let the recent rally cause you to once again become overconfident. Albert Einstein is reported to have said repeating the same behavior and expecting a different outcome is the definition of insanity.

Even if you didn't panic and sell, but found the stress of the bear market caused you to lose sleep and you were unable to enjoy your life, remember that life is too short not to enjoy it. Admit your error and correct it. Any losses caused by the error should be treated as sunk costs, the price of the lesson learned.