Why it may be worth it to embrace the bear market

If previous crises are any indication of future performance, your portfolio could fare better in the long run if you resist the urge to cash out

Did you panic?

It's the question of the moment with the wild ride that stocks have taken amid the credit crisis. Financial advisers' conventional wisdom is to stick with a long-term investing plan and not to drop out of the market when things get tough. But that's hard advice to take on days like Sept. 29 when the Dow Jones industrial average dropped a record 777 points, even though it bounced back 485 the next day.

"You must stay firm and not let these very uncertain periods rattle you," said Christine Fahlund, senior financial planner at T. Rowe Price Group, the Maryland money manager.

Financial advisers point to how markets recovered from past stumbles such as the Asian currency crisis of 1997 or the declines that followed the terror attacks of Sept. 11, 2001. An analysis by T. Rowe for the Globe, for instance, showed how over the long-term, investors who stayed in a mix of stocks and bonds did significantly better than those who switched to a bond-and-cash portfolio.

Of course, there are no assurances stocks will bounce back. There is only the probability that the market's past will be a prologue to future recoveries. "The problem is that's not an easy thing to hear in these times," Fahlund said.

No kidding. Many investors fled stocks last month, pulling $22 billion out of equity mutual funds in the four weeks ended Oct. 1, according to AMG Data Services of Arcata, Calif. Local financial advisers and bankers brim with stories of individuals asking to move their money to bonds, money market funds or insured deposit accounts that are unlikely to lose value but also have paid lower returns historically than stocks.

Yet some advisers say the real surprise is how many people actually are sitting put - there remain about $4.5 trillion in equity mutual funds overall - even though it's human nature to get defensive during bear markets.

"When you feel like someone is taking something away from you, you want to do something about it," said Will Swenson, a financial adviser in Cambridge for TIAA-CREF, the big retirement services company whose clients include universities and other nonprofits.

Swenson said he has spoken with about 150 clients in the past month, twice as many as usual, some anxious to know if they should move their money around. In nearly every case, Swenson said, the appropriate response was to do nothing - because the investors were already allocating their money according to plans they've previously developed according to factors like their expected retirement age and tolerance for risk.

"Especially with retirement accounts, it's rarely a good idea to act emotionally and in a way that could negatively impact your plan in the long run," said Swenson.

To analyze what could be called the "cost of panic," T. Rowe calculated for the Globe what would happen to a sample $100,000 "balanced" portfolio made up of 60 percent stocks and 40 percent bonds during several crises under two scenarios.

The portfolio is typical of one T. Rowe would suggest for a 55-year-old investor planning to retire in about 10 years. In the first scenario T. Rowe projected what would happen if the investor maintained the investment; in the second, T. Rowe calculated what it would be worth if the investor switched to a highly conservative mix of bonds and cash on the second day of the crisis, then kept it there.

The first crisis was the market's decline in 1997, prompted by the rapid devaluations of Asian currencies. The original portfolio did indeed do worse than one that was switched to all bonds and cash after the second day of the crisis. But over time the stocks recovered, and three years later the same portfolio would have been worth $135,176, compared with $117,216 for the bonds-and-cash portfolio.

The same portfolios would have taken a similar ride in the period from 2001 to 2004, with the investor who stuck with the balanced portfolio winding up with $113,424 and the one who switched to bonds and cash finishing at $108,933.

The crazy trading of recent weeks has borne out at least the first part of the pattern.

According to preliminary figures an investor who had $100,000 in an balanced portfolio on Sept. 15 would have had $94,567 as of the close of trading on Friday, while it would be worth $100,129.85 had it been switched to bonds and cash on Sept. 16.

The analysis oversimplifies things a bit, since it assumes the investor doesn't move back into stocks once things calm down. But it offers lessons many investors already seemed to have learned, to judge by a dozen people recently interviewed at Post Office Square, in the heart of Boston's Financial District.

"The market goes up and down, but I'm very optimistic," said David Chefitz of Sharon, who works for a benefits consulting firm and said he hasn't changed his portfolio, which he described as a diversified mix of stocks he's worked out with a financial adviser. He added that "If you look at a graph from 1929 to now, this is just one of the squiggles."

A few people were jumpier. Financial services contractor Geoffrey Dean said he moved about 25 percent of his holdings from stocks into money market funds several weeks ago, worried about signs of instability like rising oil prices and the lack of diplomatic progress with Iran.

Also, Jackie St. George, a building manager in Boston, says she's glad she moved money out of equities several weeks ago into a money market fund. "I feel like I dodged a bullet," she said Friday of recent markets. While she might earn lower returns on her investments, she said, she plans to retire in a few years and wants to keep her savings safe.

Advisers say this behavior is typical and rational: Many individual investors are more concerned with not losing money than with extra-high returns. To address that psychology, lately mutual fund firms have been passing around literature focusing on historic dips like those analyzed by T. Rowe.

"Don't miss the market's best days," admonishes Putnam Investments of Boston in materials it recently sent to financial advisers. A similar sheet from Fidelity Investments is titled "Portfolio Hazard" and shows how much less a $10,000 portfolio invested in the stocks making up the widely-used Standard & Poor's 500 index would have earned had it missed some or all of the market's best 50 days since 1980.

A portfolio left alone would have grown to be worth $267,486 by Aug. 31, 2008, while a portfolio that missed the best five days would be worth $198,617 and one that missed the best 50 days would be worth just $37,800.

"Given the market's long-term upward trend, the odds of precisely avoiding the worst-performing periods are long compared to the higher probability of missing out on positive returns," Fidelity's sheet states.

Next comes the fine print: "Past performance is not a guarantee of future results."

Ross Kerber can be reached at kerber@globe.com.