History Shows Panic Selling or Buying Is Not a Good Strategy

Investors: Hold steady.

Tuesday's terrorists attacks have left many frightened investors wondering whether they should dump stocks this coming Monday when the markets are tentatively set to open -- or, at the very least, rotate their holdings into companies or sectors that stand to gain from the tragedy. But the best strategy, substantiated by history, is not to do much, financial advisers counsel.

"We're not having anybody do anything different" because the diversified portfolios of our clients should help protect them from volatility, says Scott Leonard, president of L.A.-based Leonard Wealth Management.

Though the attack likely will slow the productivity and decrease the profits of many businesses, especially in the insurance, airline and financial industries, "it's not cataclysmic" for the economy, says Philip Cook, a certified financial planner in Torrance, Calif. "When the markets do open again, I expect to see more selling than normal. The market will drop some, but not more than somewhere between 5% and 10%."

Indeed, such a plunge could even produce bargains, some planners suggest. "A lot of smart money would see a 10% downturn as a time to put money in," Leonard says.

And if history repeats itself, stocks predicted to decrease in the next few days eventually will go back up. While there's no precedent for Tuesday's events, the market has recovered dramatically in the wake of other American catastrophes. According to Ned Davis Research, the Dow Jones Industrial Average lost 4.3% in the three weeks before America waged war against Iraq. Only two months later, the index rebounded by 19.8%.

In another example, the day following President John F. Kennedy's assassination, the Dow lost 2.9%. Two months later, the index was up 12.4%. During the eight days of the Cuban missile crisis, the market actually gained 1.1%, then went on to gain 17.1% two months later.

Of course, the biggest X factor in the current crisis is: What happens next? Another terrorist attack on U.S. soil or a substantial retaliatory attack by the U.S. would certainly fuel more panic in the markets. Given these uncertainties, holding steady remains the most reasoned approach for the individual investor.

A Warning Against Market Timing

Even in the sectors that will be hit hard by this tragedy -- airline, insurance and financial -- the financial planners advise against rash selling.

Amid so much uncertainty, market-timing in individual stocks could backfire if overwhelming negative sentiment prompts overselling in particular sectors. Leonard doubts whether the attacks even will affect most companies. "People still need to eat, need to fuel their cars, need to buy diapers -- they still need to do everything we do as human beings that drive the economy in the long run," he says.

But some selling may be wise, according to Leonard. If the market drops significantly, dump stocks for tax reasons, he says. "We'd realize those losses, go buy an exchange-traded fund for 31 days, then go back into those stocks." (According to the IRS, to be eligible for a deduction, investors must wait 30 days before buying back into a stock they've sold at a loss).

Investors seeking more security might consider moving incremental amounts of money into bonds, says Janice Hobbs, a certified financial planner at Innovative Financial Planning Services in Tustin, Calif. "If they're so worried that they can't sleep, I would suggest they move away from equities a little bit towards short-term bonds. And that's with the caution that when things turn around, bonds aren't going to move up drastically, but equities will. That's a trade-off investors have to decide they're willing to make."

With yields on both long-term and short-term bonds in the 4% to 5% range, Hobbs says the short term is a better choice, particularly for investors who want stability. "If the government begins to stimulate the economy," she explains, "that may lead to inflationary pressures again, and that would be bad for the long end of the bond curve."

In any case, individual investors aren't likely to get high priority when the market opens. By the time their trades are executed, stock prices may already have dropped significantly due to institutional selling. "The big institutions are going to get their transactions done first," says Leonard. "Even an individual investor with a $10 million portfolio is nothing to these institutions."

Indeed, Schwab's Web site urges individual investors to opt for limit or stop orders rather than market orders (executed at the best prevailing price), while also warning that because of likely volatility, even limit orders might not get executed, which is typical in a fast-moving market, a spokesperson for the firm said.

Consumer Sentiment Is Key

Financial planners say their clients currently remain more focused on the big economic picture rather than on specific sectors or alternative investing options.

Consumer sentiment will play a decisive role in determining whether the U.S. economy lapses into a recession. Morgan Stanley economist Richard Berner says in a report that "uncertainty over income and wealth prospects could deflate consumer spending growth. A loss of 1 to 2 percentage points from consumer spending growth, and a few percentage points from capital spending, might be enough to flatten the fourth quarter, or even push it into negative territory."

But if past events serve as a guide, consumer confidence eventually will rebound. And so will the stock market. Uncomfortable now, Americans may can find solace in the possibility that history does repeat itself.