Mines in the Minds of Investors

Despite the recent spate of good news from the likes of Motorola(MOT Quote) and Microsoft(MSFT Quote), we are at a danger point in the stock market.

It has little to do with the hard facts of where the market is going and everything to do with what you and I think and fear. The biggest investing mistakes have to do with these perceptions and emotions, so if we recognize the danger, perhaps we can steer clear of it. Here are five reasons I think there's danger in today's market:

The market has been down for nearly 18 months. Take a look at these numbers: The Dow Jones Industrial Average , down 10.4% from its 2000 peak as of June 30; the S&P 500 , off 19.8%; and the Nasdaq Composite Index , a whopping 57.2% lower.

The media are fanning investors' fears. Most people barely blinked in August 1997 when Money magazine's cover screamed in big red letters, "Sell Stock Now!" But after 18 months of losses, investors are more pessimistic and a lot easier to rattle.

A recent edition of The New York Times led the front page with this headline: "401(k) Accounts Are Losing Money for the First Time." That the facts in the story are not news is irrelevant. What is relevant is the way the Times chose to play the story and the effect that will have on investors.

For instance, the Times reported that the average 401(k) account shrank from $46,740 in 1999 to $41,919 in 2000 and about $41,300 now. The trend is exposing years of mistakes by employees, the Times reported, adding that the losses have led many individual workers to second-guess themselves. Those who haven't second-guessed themselves will do so now.

Last year's darlings are in the toilet. I see that in my own portfolio. At the beginning of July, I spent 10 days in Vermont at a writing program where I didn't have a telephone and got no stock market news. When I got back and looked at my portfolio, I saw that four of my stocks were trading under $10: TranSwitch(TXCC Quote), Sycamore(SCMR Quote), Nortel(NT Quote) and Lucent(LU Quote). Two of my favorites, Corning(GLW Quote) and JDS Uniphase(JDSU Quote), were under $15. This is the kind of news that gives an investor a stomachache.

The economy is iffy. Perhaps we'll squeak by and avoid recession. Unemployment is still fairly low and consumer spending is decent. But there are many tales of woe. The magazine business, which is the one I know best, is having one of its worst years. People who had their choice of editor's jobs a year ago are now begging for public relations work. Friends tell friends they are out of work and everyone gets panicky.

Online message boards are getting nasty. During the bull market, we were all eager to help each other out. Now, we often see newcomers who are looking for someone to blame for their investment mistakes.

Danger points come in both up and down markets, of course. When the market is rising, I see danger when an investor's portfolio crosses a symbolic level like $1,000, $10,000 or $100,000. Emotions surge and the investor is more likely to get a sense of false confidence and decide he's going to go for broke or, alternatively, to cash out and sit on the sidelines to preserve his nest egg. It's a kind of Las Vegas phenomenon. Today, some investors have watched their portfolio go from $50,000 to $30,000. Or $18,000. That, too, is a dangerous place to be.

All of these things spell danger to me because they create an environment, a zeitgeist, if you like, of fear and uncertainty. They encourage us to act on our emotions.

Plan of Action

So what are we going to do about it?

Recognize the role of emotions. I'd like to tell you to set your emotions aside, but I don't think that's possible unless you're going to adopt a strategy like my fellow columnist Jon Markman uses with his SuperModels. Jon's goal is to wring out the human factor. Just the numbers, please. Unless you use such a model, I don't think you can wring out emotion.

Newcomers often take me to task for what they see as my unscientific approach to investing. What I see with many investors, though, is that they believe they're being scientific and then fail to follow through. They make a decision and they discuss it and talk about why it's the right one and why the stock just can't go any lower. And then bang. They cave in and sell. Or they cave in and buy.

So I think you've got to recognize that your emotions are going to play a role. Just get them out there and set them on the table.

Face up to the realities of risk. The premium that stock investors get over bond and money market investors is not guaranteed. It comes from taking risk. If you can't take the risk, you've got to get out of the market.

Diversify to limit risk. Take another look at the stock indices for the past 18 months. While the Nasdaq was down more than 57%, the Dow, with its Old Economy stocks, was down just over 10%. For those just getting started, I often recommend the (VGSTX Quote)Vanguard STAR Fund as a single-fund portfolio. I consider this fund a poor man's financial planner because it is diversified across several Vanguard stock and bond funds at a low cost. I suspect it performs about as well as most portfolios custom designed by planners. Other conservative choices are balanced funds such as (VWELX Quote)Vanguard Wellington or (DODBX Quote)Dodge & Cox Balanced.

Stick to your guns. I know I sound like a broken record on this one, but studies show that investors who trade more earn less. The cost of trading is one factor. A bigger factor is market cycles. Different types of investments do well in different market environments. The best way to succeed as an investor is to decide which ones you want in your portfolio and then to sit tight with them.

Danger also means opportunity. We should aim to grow as investors, to gain self-confidence so that we don't cave in at the first sign of trouble. Many investors remember the 1987 crash. Some were investing in the 1973-74 bear market. They are the ones who know what to do this time. What we learn in 2000-2001 will determine how good we will be as investors going forward.