From the May 2008 issue of Boomer Market Advisor • Subscribe!

May 1, 2008

Gut reactions won't weather the recession storm

Recent headlines about the U.S. economy seem to be split between those that say a recession is on the way and those that say a recession has already begun. Truth is, due to the method in which the National Bureau of Economic Research assesses the country's economic health, we usually don't know if we are in a recession until it's well underway.

Irrespective of whether we are in -- or heading for -- a recession, it's clear that the financial markets are in difficult times. Credit continues to be impacted by the mortgage crisis, with unprecedented intervention by the Federal Reserve. The stock market is volatile, to say the least, and has been for several months.

This is not the first, nor will it be the last time that the market takes a sizable swing. Such swings seldom reflect a company's underlying value. It's more a result of investor overreaction. Unfortunately, the daily headlines don't help.

In tough times history has repeatedly shown that patient investors who maintain their investment course benefit in the long run. Usually, the worst thing an investor can do is sell out of his or her equity position after a big market run-down.

Market research firm Dalbar Inc. compared the returns earned by the average equity investor against the returns earned by the S&P 500 for the twenty-year period ending in 2006. Surprisingly, the average equity investor had a 3.9 percent average annual return while the stock market, measured by the S&P 500 Index, returned an average of 11.9 percent per year. The average investor earned nearly 8 percent less per year than the market in general. Why this disparity? Could it be that we still need someone to help us balance the scale of reason? Knee-jerk reactions without good counsel can easily lead to more financial missteps.

While there are many possible explanations for the difference, the likely cause is the investor's emotional reaction to market change. Investors sell after the market declines -- thus capturing losses. Watching some of the strongest gains slip by them while out of the market, they then reinvest after the market has moved up -- missing out on precious gains.

How can you stay on track? Elliott Smith, United Planners' vice president of investment advisory services says, "Historically, the pattern of economic recoveries, the history of response to rate cuts and -- most importantly -- the dangers of emotional decision-making point firmly toward a single message: remain patient, stay steadily on course and stick with the rational decisions you made in the calm before the storm."

Perhaps the old adage, "A man who is his own lawyer has a fool for a client" also applies to investments. A trusted financial advisor is critical to wading through the thousands of investment options, understanding the client's tolerance for risk (i.e., market volatility) and helping ensure a consistent implementation of their investment plan. Emotions should never be allowed to take control of investment decisions.

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