Three Rules to Cope with Market Turmoil

08/28/2007 12:00 am EST

Focus:

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

 Gordon Pape, editor of Internet Wealth Builder, gives investors guidance in dealing with the ups and downs of the stock market.

Investors’ nerves are taut after the wicked plunge we've seen in the stock markets. As of midday August 16, the Toronto Stock Exchange had lost all the profits that had been earned in 2007 and was still falling. The sell-off was reminiscent of the late stages of a bear market, when investors collectively decide enough is enough and dump equities at any price they can get.

Unfortunately, despite the actions by the central bankers, there could be more woes ahead. Some market watchers are predicting a drop of 20% in share prices from the mid-July record highs. So far, we are only about halfway there. So brace yourself for potentially more shock waves.

The blame for the sudden changing of market gears has been laid at the feet of the US subprime mortgage market and there is no doubt that growing housing defaults in the US are contributing significantly to world-wide nervousness over a possible credit crunch.

My view is that the subprime debacle is the proximate cause for the market turmoil, but if it hadn’t surfaced at this point there would have been some other trigger. Bull markets don’t last forever, and this one was getting pretty tired. There’s never been a record high without a pullback close behind.

So what should you do now? General rule: don’t sell into falling markets. The natural tendency when markets are plummeting is to get out at any price. That’s usually a big mistake. Markets typically overcorrect in these situations. By selling into the frenzy, you risk being taken out at an unacceptably low price.

[But] in cases where you still have a large capital gain, even after the latest selling bout, you may want to take some profits.

General rule: buy quality stocks when they’re down. For example, right now financial stocks are taking a big hit because they are seen as being particularly vulnerable to the subprime mess. Does anyone really expect the banks and insurance companies won’t recover from this setback and go on to new highs in the next few years?

General rule: maintain a proper portfolio balance. Here I’m repeating a basic principle that I’ve been preaching for years, but often people forget it in both good times and bad. For example, in recent months we’re seen investors dumping their bond holdings as concerns over rising interest rates and inflation took their toll on prices. That turned out to be a mistake. As usually happens, government bonds have rallied as stocks sold off and investors fled to safety.

If you are over-exposed to stocks, and especially if you are leveraged, you have good reason to worry. You need to take steps to redress the situation before the next shock wave hits. But do so in a rational manner—don’t make a bad situation worse.

The bottom line is that no one is comfortable in situations like this. But this, too, will pass—eventually.

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