Stock Market Mania - Critical Lessons from Last Week's Plunge

Last Updated May 9, 2010 8:12 PM EDT

Less than two weeks ago, when the stock market was booming, I wrote a column entitled "Don't Feel Too Good About This Stock Market." I'd love to say I knew what was coming but I didn't. I'd also love to say I know what this week will bring but I don't. Here's what I do know and how it may help you as an investor:

1. The way we feel about risk is unstable. Despite everything historical, I found myself expecting the market to consistently move upwards, even knowing that this was irrational recency bias. I knew that suddenly thinking I could take on more risk was a red flag and totally wrong, but that's how we roll as human beings. We hitch our risk threshold to the stock market's wagon, and when it's up we're feeling good about risky markets. Risk profile questionnaires are worthless at best, because they will only show how we theoretically feel as of a certain time.

2. We have lousy memories. Only 14 months after the devastating bottom of the bear, we all developed a sort of amnesia that caused us to forget just how risky investing is. Last week, we were reminded just how painful investing is. To stay the course though, we must remember both the good times and the bad times.

3. Small speculators are road kill. Many people think of themselves as investors, though they move in and out of stocks several times a year. In reality, they are speculators pitting themselves against mathematical models that trade in milliseconds. I've never believed in day trading but doing so now is especially dangerous.

4. Investors shouldn't be scared of what happened last week. Investing is about buying the global economy and betting on capitalism. Investing is also about the long-run. Models and mania may impact markets in the short-run and destroy millions of speculators, including Lehman Brothers and Bear Stearns. Models and mania can't do much to hurt capitalism.

My advice is to be a long-run investor. Ignore the impact of the mania and short-term impact of investment banker models that can take a thousand points off of the DOW in a matter of minutes. Know that the way we feel about risk is unstable and push yourself to take more risk in bad times and less risk in good times. And keep in mind that day trading has always been dangerous, but is even more so now that the stakes are higher. Finally, worry less about daily swings in the market and more about whether you believe in buying global businesses.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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