5 Ways to Tame Your Market Fears

Thinking of cashing out? Who isn't? But don't do anything until you've read this article.

Lisa DeAngelis and Randall Cobb look like investing geniuses right now. While the S&P 500 has dropped more than 40% since last year's peak, the Atlanta couple's retirement portfolio is sitting pretty, earning 4% or so a year.

DeAngelis, 45, and Cobb, 54, aren't stellar stock pickers; they aren't brilliant market timers either. They just have almost all of their savings in Treasury notes and cash. Always have.

"I can't stand to see my portfolio go down," DeAngelis says. "My mother, a Depression-era baby, taught me that Treasuries are the only investment that will never fail you."

Sorry, Mom: History begs to differ. Though a 4% gain may look downright spectacular these days, the all-cash-and-Treasuries approach is far from fail-safe. DeAngelis and Cobb hope that slow but steady will guarantee them an on-time retirement.

But inflation -- historically 3% a year and a projected 4.4% in 2008 -- will erode the ultra-low rates they are earning now. Over the past 80 years, intermediate-term Treasury notes have returned about 5% a year on average and 30-day Treasury bills, a cash equivalent, have earned 4%.

"One of the few guarantees this couple has, if they stay in Treasury notes, is that they'll lose money after inflation and taxes," says New York City financial adviser Gary Schatsky. "That's what I call risk."

Still, with the market in turmoil, you may be tempted -- understandably -- to follow DeAngelis and Cobb's lead and trade the long-term potential of stocks for the momentary calm of cash and bonds. You wouldn't be alone: With the safety of Treasury notes in such high demand, investors have bid up their prices, pushing the yield down to 2%.

But inflation is just one of the risks you'll face by shedding stocks. Being out of the market on the downside prevents you from enjoying the riches of the upside. Plus, trying to time the swings is costly. Between 1991 and 2004, ill-timed purchases and sales reduced mutual fund investors' average returns by 1.5 percentage points a year, a study published in the Journal of Banking & Finance found.

As a Money Magazine reader, you know all this. But it's hard to be rational when your portfolio loses 20% in 30 days and cable news is carrying around-the-clock coverage of the "panic" and "crisis." We're wired to avoid loss, and unpredictable market swings compound the problem.

"When you don't understand what's going on, you may feel fearful and out of control," says Ellen Peters, a psychologist with Decision Research, a not-for-profit that studies decision-making behavior. "That may make you perceive a much greater risk than actually exists, and you're more likely to flee the market."

The best defense is to take your day-to-day feelings out of the picture altogether, and these steps will help you do it.

Keep Your Eye on the Prize

Investing for retirement is one of those rare situations in which it's the destination, not the journey, that matters. Since the mid-1960s, the S&P 500 has gone through seven bear markets.

If you began investing in 1968 and didn't need to tap your savings immediately after drops like those in 1973-74 (down 48% from peak to trough) or 1987 (down 34%), those dips wouldn't have mattered much.

Sticking with stocks, your money would have grown more than forty-fold by October 2008. Given that long-term performance, it's clear how focusing on the daily (or hourly) fluctuations can be an exercise in unnecessary anxiety.

Instead, focus on the big goal. If you haven't yet figured out how much money you'll need for retirement, use our "How much will you need for retirement?" calculator above and to the right. Then keep your eye trained on this number as you make investment decisions. At age 40, will putting your portfolio into Treasuries give you a good shot at hitting your target? Not likely.

Figure in Risk (Sort Of)

The primary dictator of how much money you have in stocks, bonds and cash should be the amount of time you have until retirement, not your fear of loss. If you don't already know your ideal allocation, use our "Fix your asset allocation" tool to figure it out.

To beat or meet the indexes, you'll need to stay in the allocation you choose. But will you stick to your ideal mix, realistically? It's hard to know for sure. Advisers ask clients questions like "What would you do if the market dropped 20%?" to judge their stomach for uncertainty.

But the answers to these questions can be misleading. Your response may depend on what the market has done recently, even how you're feeling that day. A better way to predict how you'll behave is to look back to how you did react during previous market downturns. Did you sell stocks?

If so, your risk tolerance is low, and you'd be well served to allocate an additional 10% to 20% of your portfolio to bonds -- just be sure to keep at least 50% in stocks if you're younger than 60.

Though this may lessen your return by a small amount, it should also smooth your ride. (Dating back to 1926, a 50% large-cap stock and 50% long-term government bond portfolio returned an average of 8.4% annually vs. 9.3% for a 70%-30% split, reports Ibbotson. Yet in the worst year of that period, the more conservative portfolio lost eight percentage points less than the aggressive one.)

Plus, you'll lose less by staying more conservative than by picking a riskier mix that would cause you to sell during a stock drop. "Even young investors with a 60-year time horizon shouldn't be 100% in equities if they're going to panic when the market drops," says Francis Kinniry, a principal with Vanguard's Investment Strategy Group.

If you think you can't stomach even that amount of risk, you'll have to be a supersaver to counterbalance the market returns you'll lose out on. Use our Retirement Planner to see how much you'd need to stash yearly to make your goal with 4% returns.

Make a Statement

Once you have a goal and a strategy, put it in writing. So-called investment policy statements are meant to help you stand your ground in the face of the daily analyst rants on CNBC.

The policy should include your long-term investment goal (to retire with $5 million in 2028), your current savings ($500,000 in a 401(k) and IRAs) and what has to happen for you to get there (save 20% of income and earn an average of 6% a year).

Treat this policy as a contract. When the stock market dips, pull it out, read it over and remind yourself that you've vowed not to react to every swing.

Shut Your Eyes

To truly keep emotions from hampering decisions, prevent yourself from having to make decisions at all. Your 401(k) contributions come straight out of your paycheck; replicate that with other investments. Have a mutual fund company take regular sums from your bank account and invest the money toward your target allocation.

If the market tanks, turn off the TV and definitely don't check your portfolio, says psychologist Peters. You need only peek once a year so you can realign your allocations to fit your desired mix.

If even that look sends you scrambling for an exit, see if your 401(k) plan offers automatic rebalancing. If not, consider a target-retirement fund or balanced fund that allocates to stocks and bonds by itself.

Consult a Third Party

If you need yet another wall between your fear and your wealth, consider calling in a financial planner who charges by the hour and therefore has no stake in the investments he or she sells. (Find one at napfa.org.)

This pro can act as a last reality check before you make a move that could harm your retirement prospects. You'll have to pay for the buffer, but if it will get you to stick to stocks, it's a small price.

Planner Schatsky says he's recently fielded calls from about 60 clients who wanted him to cut back their stocks. "I've talked quite a few off that ledge," he says.

Had DeAngelis and Cobb consulted Schatsky, he says he would long ago have deterred them from their strategy -- which won't get them to their goal -- and put a considerable portion of their portfolio in equities.

Hearing this, the couple are considering a stock fund buy. "It makes sense," Cobb says. "But it still makes us queasy."