How investors should think about the shutdown

(MoneyWatch) Today we'll continue our discussion on the shutdown by exploring further the emotions financial crises cause and the risky behavior that can be generated as a result.

One of the reasons investors resort to risky behavior is because they either don't have investment plans they can stick to, or if they have plans they don't have the discipline to adhere to them. As Warren Buffett has noted, a main cause of the failure to earn market returns is "a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline)."

Take a step back now and think what would have happened if each of the 17 prior times the government shut down you bailed out of the market, incurring trading costs and, in taxable accounts, capital gains taxes. Do you think you would have benefited? How would you have known when to get back in?

There is never a safe time to invest. If you think otherwise, consider the following. The economy has performed poorly since the market bottomed out in March of 2009. It's been the worst recovery in post-war history. And we've had many crises since then to deal with. There was never a single day since then when investors could possibly have thought it safe to invest. In fact, PIMCO's Mohammed El Erian and Bill Gross predicted years, if not decades, of a poor economy and low stock returns. Yet the S&P 500 has increased from a low of 666 to about 1,700 in that time frame.

If you go to cash because of concerns over the economy, you are virtually doomed to fail because you'll never see a green light letting you know it's now safe to invest again. And if you think you see a green light, it's probably well after a period of strong returns (and you've missed the rally).

There's an overwhelming body of evidence against the ability of investors to successfully time the market -- which is why in his 1996 letter to shareholders, Buffett said, "We continue to make more money when snoring than when active." He also added this advice: "Inactivity strikes us as intelligent behavior."

As explained in my book, "Think, Act, and Invest Like Buffett," one of the greatest ironies, and tragedies, is that while Buffett is idolized by millions of investors, they not only ignore his investment advice, but also tend to do exactly the opposite of what he advises. With that in mind, let's go over the right way to think about the current situation.

First, and most important, as mentioned above your investment plan must incorporate the fact that financial crises are going to occur and that you're going to have to live through them with equanimity. The only way I know how to do that successfully is to not only have anticipated the crisis, but also to have made sure that you didn't take more risk than you had the ability, willingness and need to take. So make sure your plan is the right one for you.

Second, it's critical to understand that whatever you think you know about the situation, the market (meaning stock and bond prices) already reflect all that is knowable, which includes the uncertainty about current and future government action or inaction. That doesn't mean that the market cannot drop in the future. As a purely hypothetical example, say the market is reflecting a 50 percent chance of a default on Treasury debt. In the end, it will turn out to be either 100 percent or 0 percent.

If Congress solves the problem and we don't default, it's likely that the market would rise sharply almost immediately. You would have missed the rally, and you would now have to decide if it was safe to buy at now much higher prices. On the other hand, if we do default the market will likely drop sharply (before you could act, if you had not already sold), and now you have to decide again what to do.

The real problem for investors is that while it's tempting to think we can benefit from jumping in and out ahead of the news, there's no evidence that you, or anyone else, can forecast with greater accuracy than what's referred to as "the collective wisdom of the market."

To repeat, when there is bad news market prices already reflect the bad news. That means that the market will only continue to fall if the new information it receives is worse than already expected. And if it's worse than expected, that means it's a surprise, which by definition is unpredictable. As to listening to some guru's forecast, here's what Buffett had to say in his 1992 letter to shareholders: "We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grownups who behave in the market like children."

Third, it's critical to avoid what economist and social theorist Thomas Sowell called "stage-one thinking," namely, that bad news means stocks must go down. As we discussed, bad news is already in prices. It's important to understand that if we are pushed over the precipice and markets crater, it's certainly possible that the impact of a crash would be what forces actions by government officials to finally resolve the issue. That is often what happens. For example, do you think that the Greek, Italian, Spanish and Portuguese governments would have taken the tough measures they adopted if there were not a crisis in their bond markets? Investors who engage in this stage-two thinking, anticipating that governments and central banks will take action to address, and hopefully resolve, crises, are able to avoid the panicked selling that so many individual investors engage in.

The bottom line is this. The only way you're likely to get through both good and bad times, and earn the returns markets provide, is to have a well-developed plan that doesn't take more risk than you have the ability, willingness or need to take -- and be disciplined in adhering to it, rebalancing as required. Going to cash is never a good idea. In fact, it's a terrible idea, which is why you don't see Buffett doing it.

But if your find that your stomach is rumbling it might be that you have overestimated your ability to take risk, and a permanently lower equity allocation is in order. However, if you do act, be sure you're not making the change because of your view of current events. Instead, be sure that you're doing so because you overestimated your willingness or ability to take risk.

• How the Shutdown Affects Your Investment Plan
• What Moves Stock Prices?
• 4 Lessons Every Long-Term Investor Must Learn

If the above isn't sufficient to convince you to avoid listening to your stomach, I offer the following suggestion. Before taking any action ask yourself the following six questions:

• Is Warren Buffett acting on this expert's opinion? (In this particular case he isn't selling.)
• If he isn't, should I be doing so?
• What do I know that Buffett doesn't?
• If I make this change and I am right, what impact will it have on my life?
• What impact will it have if I am wrong?
• Have I been wrong before?

If you're honest with your answers, you'll come to the right conclusion.

Image courtesy of Flickr user KAZ Vorpal