Sit Tight and Batten Down the Hatches

The worldwide collapse of stock prices has many victims -- pension funds, insurance companies, hedge funds , financial services firms. But those are players who, if they are smart, have the wherewithal to withstand a steep selloff . Some will even use short-sales or derivatives bets to profit on falling prices.

What about the small investor, the individual who is socking away modest sums for retirement or college costs? Should small investors rush for the sidelines? Or should they view this as a buying opportunity and plough more money into the market?

Neither, according to the majority of experts Knowledge@Wharton interviewed in recent days as the markets rushed downward: Wharton finance professors Jeremy Siegel, Richard Marston, Richard Herring and Franklin Allen; Jack Bogle, founder of the Vanguard Group, the mutual fund company; and Princeton economics professor Burton J. Malkiel, author of A Random Walk Down Wall Street.

Get Your Financial Plan Recession-Ready

While Wharton's Allen says investors would be smart to flee stocks for the safety of short-term Treasury securities, most of the others suggest that the best response is no response at all -- to sit tight and assume that, over the long run, stocks will continue to produce the inflation - and bond -beating returns they have for more than a century.

If a small investor were inclined to do anything, the best move would be to regularly adjust one's holdings as assets change value in order to keep to the desired allocation between stocks, bonds and cash, they say. "I think that the most obvious moves -- shorting financial [company stocks], loading up on emerging markets -- are already priced in such a way that they will not yield excess returns," says Herring. "I'm highly skeptical about the ability of most investors to predict turning points. I think most people would be best served by staying with their strategic allocations and rebalancing if market moves have taken them too far from their targets. Sorry, but it's perfectly standard advice."

More Bad News to Come?

Allen, the gloomiest of the six, says the U.S. could plunge into a sustained downturn like the one that plagued Japan in the 1990s. "People thought things could get back on track very quickly and they didn't. That's one scenario that could happen here." He recommends a highly defensive position of shifting assets to short-term Treasury securities. Even bank savings may be unattractive because, while they are federally insured, customers could face delays in obtaining their funds after a bank collapse, he warns.

Allen worries that there is much more bad news to come as the credit crisis broadens from subprime mortgages to credit cards and other kinds of debt . The Federal Reserve , he notes, has repeatedly underestimated problems, first saying the subprime crisis was contained and then saying a recession could be averted. In addition, many institutional investors and financial firms are holding securities such as mortgage-backed bonds that are now impossible to value accurately, and it may be some time before this confusion clears. "There's a lot of risk at the moment," Allen says. "I don't think people understand much what's going on."

While economic data is showing a slowdown in the U.S. and pointing to an ever-growing likelihood of a recession, that information is not of much use to investors, says Marston, adding that even if one knew the exact dates a recession would begin and end, it would not be possible to predict stock-market moves.

"In order to be successful in shifting towards cash and then back to stocks, we must first be able to determine whether we are indeed going into a recession," Marston notes. "We won't know that until about 12 to 18 months after the recession begins. That is the average time it takes the NBER [National Bureau of Economic Research] business cycle dating committee to decide that a recession has begun." The National Bureau of Economic Research is the non-profit research organization that identifies recessions' beginnings and endings, always after the fact because of delays in collecting data.