Act Fast and Kiss Your Returns Goodbye

The market was not very kind as this year began. In the dawning months of 2008, the S&P 500 index continued a drop that began last fall, before recently recovering. While the market overall is down only 2% year to date, many individual stocks have suffered worse.

Watching your nest egg slowly bleed out is about as much fun as, well, slowly bleeding. But one thing should be clear: Down months will happen in your investing career. Protracted slumps will happen. Harsh years like we saw in 2001 and 2002 will happen.

Markets slump, stocks drop, you lose money
The pattern's as inevitable as it is frustrating. And frustration often leads investors to ignore the stock advice that my comrade Tim Hanson and I found will make you rich:

1. A consistent philosophy.
2. A sense of perspective.
3. Daily discipline.

See, while some of 2008's losses were significant to the long-term prospects of a business -- bond insurer Ambac Financial (NYSE: ABK), down 86% year to date, comes to mind -- many (even most) stocks were simply dragged down with the current.

The most dangerous thing you can do in those cases is to lose your sense of perspective. Because once you do that, you'll convince yourself that you need to do something.

While cutting ties with a stock whose fundamentals have changed is wise, doing so for the sake of doing something is trouble, pure and simple. And it reeks of desperation. More often than not, doing something means changing course -- selling losers, chasing winners, or sitting on the sidelines until things aren't as bleak.

Getting stampeded
Consider this paradox: "An investor who became unduly discouraged by a market drop and who allowed himself to be stampeded into selling at a poor price was 'perversely transforming his basic advantage into a basic disadvantage.'"

That's from Roger Lowenstein's superb biography of Warren Buffett. The quoted section comes from Buffett's teacher, Ben Graham, who wrote that in the 1930s.

More recently, in their annual report to fundholders, Vanguard Strategic Equity bosses James Troyer and Joel Dickson spoke to the ills of losing a sense of perspective: "Betting on style requires that you be right twice -- when you initially make the bet and when you remove it. Being wrong on either decision can wreck the return of your portfolio."

Soccer really does explain the world
The next time you experience a down day or portfolio gyration, think about those words of wisdom before jumping from one strategy to another. Or even better: Don't do anything at all. (One good way to handle volatility is to simply not quote your stocks so much.)

In a recently released study, "Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks," five Israeli professors found that while "the utility-maximizing behavior for goalkeepers is to stay in the goal's center during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left."

In other words, in a high-stress situation, the most efficient decision -- inactivity -- was taken only 6% of the time. The researchers hypothesized that the reason for the discrepancy was "action bias":

According to the norm theory, people have stronger feelings associated with outcomes when they come from abnormal causes. Consequently, because the norm is that goalkeepers jump to one of the sides, the disutility associated with missing a ball might be greater following a non-common behavior (staying in the center) than following normal behavior (jumping to the side).

Next time you find yourself with an itchy trigger finger on a tough market day, remember the plight of the elite soccer goalkeeper.

Inactivity in action
Over the past decade, the market has seen bullish runs and bearish ones; dot-com irrational exuberance; corporate corruption and the resulting legislation; 9/11 and its wake; and now a global credit crisis. The market has been more up than down, yet there have been many down days, weeks, and months. Look at how some strong businesses weathered the 10-year span of January 1998 to January of this year:

Company	Return, Jan. 1998 to Jan. 2008	No. of Down Years	No. of Years Down by 20% or More
QLogic (Nasdaq: QLGC)	670%	6	4
Echostar Communications (Nasdaq: DISH)	1,757%	4	1
Fuel Tech (Nasdaq: FTEK)	1,410%	4	2
SanDisk (Nasdaq: SNDK)	553%	6	5
Occidental Petroleum (NYSE: OXY)	622%	1	1
Freeport-McMoRan (NYSE: FCX)	706%	3	2

Screening and data courtesy of Capital IQ, a division of Standard & Poor's. Returns adjusted for dividends.

As you can see, long-haul outperformers typically swing year to year, even though a 10-year chart would show a somewhat smoother upward trajectory. Freeport-McMoRan, an absolute monster performer, actually declined by 30% or more twice in the past decade.

The actions you should be taking
This isn't to say you should never sell. It's just that you should be investing with your brain, not your emotions. Without a sense of perspective, you don't have a chance of long-term wealth creation in the market. So make it your resolution today to steel your stomach and change your mind-set: Fortunes are made over decades by investing in high-quality companies at good prices.

Copyright © 2008 Universal Press Syndicate.