Dion Money Management Blog   Money Management for Retirees and Their Families

The record volatility in the stock market last year was enough to rattle the steeliest investor’s resolve. Naturally, the first inclination most of us have during these periods is either to head for the safety of bonds or to cash out of the markets entirely. Usually, we resist this urge. If we don’t need our money right away, we may be able to sit back—albeit uneasily—and console ourselves with some bit of wisdom or maybe a statistic we read somewhere about how “the market always comes back.” Those of us in or nearing retirement may take a very different view of things. As we watch our investments shrink in value, the prospect of living on a reduced income prompts us to take some sort of action.

That’s almost always a bad idea.

That bit of wisdom you’ve heard about the markets coming back is on target. Historically, corrections of 10 percent—or even more—in the markets aren’t unusual. In fact, they’re the norm. Stock prices, which represent the present discounted value of a company’s future stream of earnings, are inherently volatile. Over the long term, however, the path of the overall stock market has been upward. Investors who keep their assets working for them through short-term gyrations are better positioned to take advantage of the big moves to the upside than those who try to time the markets in an attempt to avoid the drops.

In the parlance of professional money managers, investors who cash out or head to safe havens like bonds during periods of stock market volatility take “opportunity risks” with their money. In other words, market timers are likely to miss out on the best chances at generating a good return on their investments. According to data from Fidelity’s Market Analysis, Research and Education group, the S&P 500’s five best-performing days from January 1980 through December 2006 accounted for 26 percent of its return. What’s even more amazing, the S&P 500’s 30 best-performing days accounted for 73 percent of its return during this period.

So the big moves to the upside are rare: 30 days in 26 years. But wouldn’t it be possible to hit those 30 days simply by generally staying invested when the economy is doing well and getting out when it tanks? The short answer is no. Indeed, as the data indicates, quite the opposite seems to be the case. According to Fidelity, since 1926, the best five-year period for the market began in May 1932, during the Great Depression. Investors saw a 367 percent return in the ensuing five years. The second-best period began in July 1982, in the midst of a pronounced recession.

Most market timers, however, don’t pile into stocks during these rocky periods. Rather, they wait until economic conditions improve—and stocks go up—before buying. To put it another way, market timers typically mis-time their trades and wind up “buying high” at prices above where they sold.

For do-it-yourself investors, thoroughly researching a stock or fund before buying it and then holding that investment for the long term makes far more sense than moving in and out of the market based on the latest headline or earnings report. Our emotions, however, can easily overwhelm our facilities for rational decision-making, particularly when the markets become volatile. There is an entire field of academic study devoted to understanding why we make certain investment and economic decisions called behavioral finance. Researchers know that even the most sober-minded among us can become irrational risk-takers when it comes to avoiding a monetary loss. Behavioral finance studies also demonstrate that when dealing with the stocks, bonds, ETFs, and other securities we’ve selected, we have a tendency to be overconfident and to move with the herd.

While a short-term, paper loss is certainly unnerving, missing a key day of market gains—or exacerbating losses by improperly timing market exits and reentries—can do real damage to years of careful planning and investing. At a certain point, some of us may come to realize that our portfolios are too big, too complicated, or simply too important to our future well-being to be managed alone. A professional adviser who acts in your best interests but at an emotional distance from your portfolio can insulate your holdings from occasionally irrational and costly mistakes.