Written by Nathan White, CFA

photo by epicharmus

What should you do as an investor when financial markets become so gripped by fear and negativity that it seems the selling will only get worse? When everyone is so focused on the bad news and negative prognostications their attention focuses on protecting downside risk. I’ve mentioned this in previous articles, but what about the risk of an upside move?

When the markets get this volatile and everyone is getting a good beating the nervous investor sells and goes to cash. Because they were not allocated according to their risk tolerance they find out the hard way they can not withstand the volatility. I have often seen how an individual in this situation becomes so averse to losses that they run to CD’s or a low-yielding government bond. They have now effectively locked in their loss and capped their future return.

Why is it so important to stay invested in the current negative market enviornment? Because if you miss out on the rally that will inevitably come after the current sell-off you may end up missing out on the majority of the gains that will come for some time. Our economy has become so addicted  to credit that it takes $3.50 of credit for every dollar of GDP growth. We kept taking on more and more debt to get more growth and realizing diminishing marginal returns from each increase in credit. Now take away the effect of credit as is now occurring and the future growth potential of the economy is severely diminished.