Don't Run to the Sidelines When the Market Falls

Sometimes, you have to forget some things in order to learn others.

web-773-112013-091202_bull_bear_02.jpgThis is especially true in matters of personal family finance. One of the most challenging aspects of being a good steward of your family’s assets is that it often involves acting in ways that are contrary to our nature.

For instance, take our reaction to frightful drops in the stock market.

From infancy we learn that when something causes us pain, we need to change course — to do something different as quickly as possible.

This “action-reaction” cycle is not only something each of us learns through experience. From an evolutionary standpoint, we are born hard-wired to change our behavior in response to negative stimuli. It is a basic part of what it means to be human.

It is no surprise then, that when we feel the psychic pain of a declining stock market, most of us have a gut feeling that we want to make a change.

Indeed, the industry has even created a nice euphemism for those who decide to move out of the stock market when the going gets rough — commentators call it “moving to the sidelines.”

It is perfectly natural to consider moving to the sidelines after enduring a precipitous decline in the stock market. It’s also usually the wrong thing to do, especially if you have a long-term investment perspective. It is hard to win any game in which you are sitting on the sidelines.

Studies have repeatedly shown that most investors, including the pros, cannot consistently predict when the market is going to go up or down.

As a result, moving to the sidelines during bad periods tends to lead investors into a pattern in which they “sell low” (after the market drops) and “buy high” (after the market has already moved back in the positive direction).

This is the opposite of the “buy low, sell high” goal all investors should aspire to.

To illustrate the “sell low, buy high” phenomena, consider the days after Sept. 11, 2001. Lots of people sold stocks the week after the attacks, not because their particular stocks were threatened by the events, but because of a general fear of market collapse.

Most of those who did so lost more money as a result, unless they jumped right back into the game.

In fact, people who chose to move to the stock market sidelines for a mere four weeks after Sept. 11, missed out on a period in which the broader market rose 5 percent to 10 percent.

To date, there has been no opportunity for an investor to have made up this lost ground.

Managing family finances is full of situations like this — where we have to overcome otherwise prudent habits and practices in order to make the best of our financial situation.

Another example is estate planning.

There are huge incentives for people to make sure their estates are structured in the most effective manner possible.

A well-planned estate not only can create a legacy of sound asset management and good will across the generations, it can also save lots of taxes.

There are a surprising number of upper-middle class families that could potentially save themselves hundreds of thousands of dollars (if not millions) in taxes by carefully planning their estates.

In spite of these potential benefits, many people have not implemented the estate planning strategies they need. And it is not just because they are busy.

I believe that there is another, even more powerful reason that people do not get around to estate planning.

It has to do with stress, and our usually sensible desire to avoid it.

Research coming out of the insurance industry has documented that of all the things that can happen to someone — divorce, job loss, having a baby — there nothing as stress-inducing as the death of family members.

It is hard enough to contemplate our own deaths.

It is even more stressful to contemplate the death of a spouse — or even worse (according to the research), one of our children.

Nobody should be surprised then that so many people do not get around to planning their estates.

Whether we are conscious of it, it is stressful for people to talk about what should happen when they, their spouse, and/or their children die.

Yet, that is what we all need to do.

Whether you are motivated by having a plan in place to manage your medical care, by making it easy for your spouse to manage financially without you, or by reducing taxes, crafting a good estate plan will, in the long run, significantly reduce the stress faced by you and your family.

Responding to dramatic market swings and planning estates are but two situations in which our otherwise healthy ways of thinking and acting can lead to unhealthy financial results for our families.

The first step is to recognize this paradoxical dynamic.

The second is to do something about it.