The Daily Interview: Why Investors Shouldn't Panic

Russ Kinnel Director of Fund Analysis, Morningstar

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With the Dow dropping nearly 1,400 points last week, many investors may be running scared.

But they shouldn't panic and dump all their holdings, says Russ Kinnel, director of fund analysis at Morningstar, because doing so could leave investors out of the market just when it begins to turn around. The better thing to do is make sure one's portfolio is diversified and remain patient.

TSC: There are a lot of things going on that are cause for tremendous concern. The economy has been suffering, and there seems to be even more doubt as to when it will recover, given the state of the nation. What would you advise investors to think about at this time?

Kinnel: There are a couple of key points to keep in mind. First, you want to look at your financial situation as unemotionally as you can, as hard as that is. It's very natural to want to go into the most conservative investments possible, but there is a real danger in that.

Markets are still unpredictable, and often when it seems inevitable that they will go down more is when they turn around. Short-term market movements are one of the most difficult things to predict, and lots of very smart investors have made their biggest blunders in trying to guess where the markets are going. Jeff Vinick, previous manager of (FMAGX Quote)Fidelity Magellan, one of the smartest fund managers, still made a huge gaffe by betting against the market. He sold his growth stocks and bought bonds and value back in 1995. The market ended up coming back very strongly, and he was in bonds. He missed out.

Investors need to appreciate that while it seems like it's possible to predict the direction of the market, it really doesn't work that way. Diversification is the best defense in times like this. It doesn't eliminate losses in a bear market, but it reduces them and keeps you in the game.

TSC: Can you think of any other time like this when the market moved in such an unpredictable direction?

Kinnel: In the Persian Gulf War in '91, investors decided that when the war started, the market would go down and oil would go up. But the bad news had already been priced in along with some short pressure. In fact, once the war started, the market shot up because there were lots of people waiting to buy. Those that had gotten out missed out on that.

TSC: So you're saying the best thing that people should do right now is stick with the stock market?

Kinnel: Stay with your plan. If you haven't developed a good investment plan, then maybe you should make some changes. Kick the tires and see if you are diversified among stocks -- value and growth, small-cap and large-cap, foreign and U.S. -- and that you do have a bond component. Experiencing both the downside and the upside is what the risk premium in a diversified portfolio is, unfortunately.

TSC: Do you think investors will continue to have faith in the market?

Kinnel: Yes, realistic investors will continue to realize that you still have to save and invest in order to reach your goals, even in this time of greatly reduced expectations.

People know that Social Security isn't going to be enough, and 3% returns in a money market account isn't going to be enough. Investors who are being extremely cautious and moving everything into cash are forgetting about opportunity costs and inflation. Investing is about probability and putting the odds in your favor, and taking no equity risk is perhaps the most foolish risk of all.