BOSTON – If the stock market's big decline Tuesday made you nervous, try the following: Take a red marker and make a big X on Feb. 27 in your calendar. Make no other marks or notations. Then go about your regular business for the next 10 months.
When the end of the year rolls around — assuming you review your calendar before you either file it or toss it — see if you remember why you actually made Tuesday a red-letter day.
Chances are the 416-point decline in the Dow Jones Industrial Average will pass, just like so many others before it. And what investors need to keep in mind is that there have been many others; while Tuesday's drop represents the seventh-largest point drop in Dow history, at 3.27 percent it is just the 37th-largest percentage decline day since 1950. In percentage terms, if you go back to 1900, you'd have another 200 days where the Dow suffered bigger losses.
As the old song says, Mama said there'd be days like this. On the Dow, on average, there's one every 18 months or so.
While the size of the decline may have been a surprise, plenty of investors seem to have been expecting something. On Monday, the UBS/Gallup Index of Investor Optimism for February showed a significant decline from January; despite the decline in optimism, the survey showed that two-thirds of Americans still feel it's a good time to invest.
The falling optimism/good-time-to-invest dichotomy highlights what some observers believe is complacency on the part of investors.
"It's not that we have seen a euphoric bullishness," says James Stack, editor of the Investech newsletter, "but more of a comfortable complacency. Investors have now gone almost four years — 47 months — without a 10 percent correction in the blue-chip indexes. That's the second-longest period in the history of the Standard & Poor's 500, and I think it has lulled a lot of people into a sense that the market's not going down any time soon."
Having now seen the market take a shot in the gut, the question is whether investors will be knocked from complacency into overdrive, making the kind of short-run moves that blow up long-term strategies.
"For the average investor holding a diversified portfolio with a long time horizon, this is just a bump in the road, something you may notice when it happens, but which you don't really remember when you reach your destination," says Terrance Odean, a finance professor at the University of California, Berkeley, who researches investor behavior.
"This kind of drop is emotional, it makes people want to panic, it makes them want to watch the news all the time, it makes them want to do something. Instead, they should put away the paper, turn off the television and go to the beach or go skiing. When you're emotional, it's not the time to make major reallocation decisions."
That doesn't mean that investors should ignore the big decline or what might happen next. Instead, it's a good gauge of risk and pain tolerance.
Had the market gained more than 3 percent in a single day, no one would have been complaining, even though the size of the move illustrates current volatility; no one minds when the market is volatile in their favor.
"Investors would be delighted with a 400-point gain and emotional about a 400-point loss because they don't have a solid idea of what they really need over time, and they are focused on what is happening today," says Donald MacGregor of MacGregor-Bates Inc., a Eugene, Ore.-based firm that does research in judgment and decision-making. "In times like these, you really need to understand yourself emotionally."
That being the case, the question for most investors is whether the market's big drop, and whatever comes next, actually forces a change in behavior, the proverbial reach for antacids to calm the stomach.
The point of marking the calendar is that virtually every big market drop becomes routine in time. Nearly 20 years after the market crash of 1987, for example, there is not a crowd of people claiming that they would be able to retire today, rather than working a few years past age 65, if they had only been out of the market on that particularly bad day. The market plunged more than 22 percent on Oct. 19, 1987.
"You have seen this before, and while the finer points and circumstances are different, the truth is that this will not be serious stuff as it relates to your lifetime as an investor," says Meir Statman, a Santa Clara (Calif.) University professor who studies behavioral finance. "The people who ride out the market now may have some short-term stomach pain, but they won't have the long-term pain that comes from ripping up their portfolio at the wrong time."
Statman suggests that average investors should put in their own "circuit-breaker," akin to what the stock exchanges use to steady the market on big-move days. His idea is a 10-day moratorium on making portfolio changes, so that an investor who woke up Tuesday morning feeling like they had a reasonable strategy in place should not consider altering that strategy until they have lived with the perceived pain long enough to know they can no longer sleep at night.
That strategy would upset market-timers, but most investors aren't trying to time the market.
"If you want to do something after the market has one big down day, take a sleeping pill," says Statman. "If you're still feeling it after 10 days — when you see what the market does next — then maybe it's time to make a change, but just maybe. All of the research shows that you're more likely to hurt yourself making changes after days like this than you are to help yourself."
Copyright (c) 2006 MarketWatch, Inc.