What's Your Rationale? Taking the Blinders Off on the Market

Many investors cling to myths, and it's hurting them as the market weakens.
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To paraphrase Jeff Goldblum's character in The Big Chill: Have you gone a day without rationalization?

Probably not.

We do it on a personal level: "When the holidays are over, I'll start the diet. A few extra pounds is good in the winter anyway."

We also do it about the stock market:

"When tax-loss selling is over, the market will rebound."

"We're getting close to a new president finally, so things will settle down."

"The

Nasdaq

is down nearly 50% since its March 10 peak; that means the market is a bargain."

But we all know that the diet has to begin before the cookies are swallowed; only hindsight tells us what it takes for the market to rebound.

People have a tremendous ability to rationalize though, notes Jeffrey Heisler, an assistant professor of finance specializing in behavioral finance at

Boston University

. And the current market is offering us many opportunities to conjure up myths and validations to help placate us as we examine our dwindling portfolios.

So let's go through a few of these myths and dispel any reliance you may have on them.

Myth 1: The market always goes up.

Maybe over time. But on a short-term basis, forget it. So if you don't have the stomach for a roller coaster ride, get out. Your portfolio must be prepared for oscillations.

These kinds of market cycles do occur, reminds Heisler. "And I don't think this one is unprecedented in terms of its size." We've had some short-term dips, but we haven't seen a bear market like the one we had in 1973-1974, so our expectations are jaded.

And our memories are short-lived. "It was really just the fourth quarter of 1999 that was good, otherwise last year was not all that great either," reminds Rick Adkins, a certified financial planner and CEO of

Arkansas Financial Group

. "Third-quarter '99 was just as bloody as 3Q 2000."

Over time, history has shown that the market will continue to rise, but no one can tell you when or how long it will take for your portfolio's returns to increase again. It could take 20 years for you to make the money you could've made back in March. "It took us 20 years to recover from the 1929 crash," says Heisler. Granted, that was a very different time, but it reminds us that change may not happen overnight.

Myth 2: If I bought a stock at 100, I should wait until it gets back there before I sell it.

Many of us are guilty of this one.

Studies show that investors tend to hold on to losing investments because they believe they will bounce back, says Terrance Odean, an assistant professor at the Graduate School of Management at the

University of California at Davis

. "How could the stock be worth $50 a month ago but only $15 today? The rationalization is that it's got to come back."

But that may not always be the case. Will

Microsoft

(MSFT) - Get Report

ever see $140 again? Based on the current litigation, it's very hard to tell. But was it worth that price to begin with? "Ask yourself what should the stock price should be in a nonhyperactive, Ritalin-induced world," suggests Bill Fleming, director of personal financial services for

PricewaterhouseCoopers

in Hartford, Conn.

And even though things seem to be in the toilet these days, be aware that there still may be overinflated stocks out there. Take

Amazon.com

(AMZN) - Get Report

, suggests Dr. Andrew Subramanyam, finance professor at the Anderson School of the

University of California at Los Angeles

. "It's fallen around 50%, and it's still not trading at reasonable numbers. It should be at $10 to $15 a share based on our valuations." The stock closed at $25.56 Monday.

It's imperative that you understand the company, its industry and the futures of both. If the reasons you bought the stock are the same, then ride it out. But if you've lost confidence in the company, then it may be a good time to bail before things get worse.

Myth 3: I need to jump into a stock when it's at its low and get out at its high.

Buy low, sell high is Rule No. 1. It's easy to say, but to do it, you have to guess right twice. "If anyone knew how to do that, they'd be worth zillions," says Adkins.

The problem is that while buying on the dips has worked in the past, this year has been an exception. "This year it just goes lower when you enter," says Heisler.

Very few people can time the market. Leave it to the pros and don't get caught up in that game. Buy good companies that have strong projected growth rates and sit still. If you're in it for the long haul, you won't need to worry about selling unless the fundamentals have changed.

Myth 4: It can't get any worse.

As bearish as things seem, many will argue that we still have room to drop, at least in the tech sector. "Even if things get resolved

i.e., tax-loss selling ends, we pick a president, the cash on the sidelines comes rushing back in, a lot of stocks are still selling at

price-to-earnings ratios of close to 100," says Bryan Olson, director at

Charles Schwab's Center for Investment Research

. "We've come down a lot -- but can we come down further."

Take

Cisco

(CSCO) - Get Report

. Its 12-month trailing P/E is around 120, while its computer-networking peers' P/Es are hovering at 33, according to

Marketguide.com. Sure, it has predicted a 53% five-year growth rate, but so have its industry peers. While it's the market leader and a great company, it's arguable that Cisco's stock is still overvalued.

UCLA's Subramanyam predicts a roughly 10% drop in the tech sector over next year.

Myth 5: I'll wait for everything to get back to normal.

But what's normal? In retrospect, we know now that last year was abnormal, but did we know it then?

Your risk assessment will determine if you are in a "normal" market period. Are you scared that you're going to lose everything? Are you lying awake at night and tuned in to

CNBC

all day?

Here's a tip: That's not normal. Your portfolio may be too risky. While it might not be the best time economically to makes changes to it, psychologically you may be better off.

Consider selling some losers or buying some stalwarts to help your diversification. If you have loser positions in a sector in which you are too heavily weighted or in companies in which you've lost faith, consider selling some shares before year-end. Your tax return will thank you in April.

And there are many people out there who believe the overall market (Reminder: That does not mean the Nasdaq.) is undervalued, so you may have a buying opportunity on your hands. "We show the market's 18% undervalued, says Tracy Eichler, investment strategist at

PaineWebber

in New York. "And it hasn't been here since the fall of 1998 with the fall of the Russian ruble and the

collapse of

the infamous hedge fund

Long Term Capital Management

." While others see the market as being around 10% undervalued, if you have cash lying around, this may be a good chance to diversify your portfolio and buy some nontech stocks.

And yes, it may mean moving some money to fixed income. The markets fell close to 30% in the '70s; that could happen again. Create a portfolio that can weather that storm.

So rationalize all you want if it makes you sleep better at night. But don't try to fool yourself. Think realistically and understand your portfolio and its positions.

And while you're at it, cut back on the cookies.

So, what are some of the other rationalizations out there that aren't going away? People aren't talking about a rally after tax-loss selling anymore. What are people clinging to as the next hope for a return of the bull? A January rally? The Fed easing rates? Send your suggestions -- as well as questions and comments on other matters -- to investorforum@thestreet.com, and please include your first and last names. Investor Forum appears Tuesdays, Thursdays and Saturdays.

TSC Investor Forum aims to provide general investment information. It cannot and does not attempt to provide individual advice. All readers are urged to consult with a professional as needed about their individual circumstances.