I’ve written about the advantages of making investment decisions based on reason rather than emotion. The downtrend in stock prices that began late in 2007 has tested the nerves of even the most experienced investors. In particular, based upon the calls and e-mails I received, the market action during the week of Oct. 5 sent many investors into a panic.

It was not uncommon to hear investors complain that their accounts have been devastated and express fear that they may lose everything. I have to admit that even I experienced flashes of fear during that week. After all, I’m responsible for the retirement plans of hundreds of families, in addition to my own.

The question I fielded most, from clients and readers, is: “What should I do now?” Most commonly, Thrift Savings Plan investors asked me one of two questions: “Should I move my money out of the C, S and I funds before they fall further?” or “Should I delay moving my money out of the C, S and I fund shares until they recover?”

I sometimes heard these two questions from the same TSP investor during the same conversation. On one hand, these investors wanted to avoid the risk of further loss, and on the other, they wanted to avoid the risk of missing gains. In every case, the underlying desire was to put an end to the fear they were experiencing – a perfectly reasonable objective.

But these questions miss the target. The solution to the problem does not lie in making investment decisions in response to what has just happened in the market. This is a common mistake. What just happened in the markets can’t be avoided – it has already happened. Selling your shares in the C Fund after they have fallen 40 percent in value does nothing to reverse the loss. Similarly, refusing to sell shares that have lost value because you feel “they owe it to you” to recover their value is a mistake. If your investment strategy or need for cash suggest that you sell the shares, holding them because they are “low” is a mistake.

The question to ask when considering what to do is simple: “Regardless of what has just happened, what should I expect from this point forward?” As I have mentioned in my columns before, I expect the C Fund to produce a return of about 12 percent each year. This is based on the performance of large domestic company stocks – which the C Fund represents – over the past 85 years. The fact that the value of shares in the C Fund have fallen over the past day, month or year does not change my expectation.

The logic is the same as that which tells me that even though I flip three heads in a row using a fair coin, the probability of flipping heads on the next toss is still 50 percent. Even if you believe that recent price movements somehow affect future price movements, you wouldn’t lower your expectations for returns after prices have fallen, would you? Many TSP investors act as though this is their practice – prices fall and then they sell their shares.

Increased expected rates of return demand that you accept increased investment risk. If you’ve properly diversified your investment holdings, there’s nothing you can do to alter this fundamental reality. If you’re managing your TSP account properly, you’re only taking the risk you need to take to achieve your goals in the first place.

Trading your account in response to recent price activity only increases the risk you bear, without increasing the rate of return you should expect to receive from your account. Shifting from stocks to cash, for example, when you’re relying on the returns expected from stocks to make your retirement plan work, only increases the risk that you’ll fail to realize the returns you’ll need in the future.

If you want to maximize the odds that you will succeed in achieving your goals, the formula is simple:

  • Identify and understand your financial goals.
  • Select an investment strategy that will support your goals with a minimum of risk.
  • Implement that strategy in your investment accounts.
  • Review your plan regularly.
  • Rebalance your portfolio accordingly.

Notice that this formula does not include anything about reacting emotionally to short-term market moves. Replacing reason with emotion will only hurt your chances of success.

Written by Mike Miles
For the Federal Times
Publication December 27, 2008