Last Updated Nov 16, 2009 3:57 PM EST
This is by far the most common question I've been asked over the past month. Yet, do I think this is the most irrational question? Definitely not and here's why.
A little background
On March 9th of this year, the U.S. and international stock markets bottomed out, losing more than 50% of their value from their height. Since that time, however, markets recovered dramatically with U.S. markets up about 65% and international markets gaining 90%. I wish the math worked out that a 50% loss followed by a 65% gain was a positive return, but it doesn't. The stock markets are still down over 25% from that all time high.
Reliving the past
Before I explain why asking if the time is right to get back into the market is not the most irrational question, let me relive some painful moments of last March. The stock market was in free fall, the U.S. economy was sinking faster than the Titanic, and The Great Depression Ahead was the latest, apocalypse-of-the-moment best seller. The mantra of the day was that capitalism was dead.
You may realize where I'm going with this when I say the most common question I was getting at the time was "Is now the time to get out of the stock market?" And I was only getting this question from the people who hadn't already panicked and bailed out.
The irrationality of our statements
From an emotional standpoint, both questions make perfect sense. But from an economic standpoint, here is what investors are really asking.
March - Now that the stock market is having a half off sale, should I sell?
Today - Now that the half off sale is over and prices have skyrocketed, should I buy?
Statements such as these are both irrational and predictable, because they are driven by our emotions rather than pure economics. It is this emotionally driven force that points us in the direction of buying high and selling low. The knee-jerk tendency we have to consistently do the wrong thing at the wrong time is why, on average, investors underperform the market by about 1.5% annually, over and above costs.
Overall, our human instincts have historically served us well and kept us alive. Yet the instincts of fear and greed have failed us miserably when it comes to investing. Buying high and selling low may feel like the thing to do at the time, but it's absolutely the wrong thing to do at any time.
You shouldn't ever make your financial decisions based on feelings. What investors should do is pick an asset allocation and stick to it. That's the one way you can break free of the herd mentality and avoid following them off the next cliff. Be warned though, sticking to an allocation means rebalancing, which forces you to be buying when everyone is selling and selling when everyone is buying.
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