Investing: Stay cool when news gets scary

(Money Magazine) -- You learned in high school physics that for every action there's an equal and opposite reaction. A similar law affects investors. For every unexpected crisis, count on some to overreact.

In April, a negative report on the creditworthiness of U.S. debt sent the stock market into a oneday tizzy -- even though Treasury bonds hardly budged.

Before that was the Japanese tsunami. The massive scale of the destruction warranted a huge response -- from relief agencies and emergency workers and radiation specialists. Just not from U.S. stock investors. The market sank nearly 5% in the days immediately following the disaster, and investors who had been plowing money into domestic-stock funds turned around and pulled billions out. ('We will have another crisis...')

But they did so just as the markets were rebounding. Today the S&P 500 index is actually 3% higher than before the crisis -- and a lot of wealth has been transferred from the fearful to the cool-headed.

"The worst thing you can do is hit the panic button when something like this pops up, because you'll inevitably get the timing wrong," says Mark Luschini, chief investment strategist for Janney Montgomery Scott.

Still, you'll face lots of temptation to do so. It's not uncommon to face several external market shocks (natural disasters, oil spills, coups, terrorism) in a single year.

So how do you steel your nerves when the next crisis erupts? Follow this five-step path to inner calm in frightening times. ('My biggest money mistake')

In the midst of a crisis, it's always hard to gauge the true scale of the economic impact. "Yet history tells us that external events and crises -- as devastating and dire as they seem at the time -- very seldom have any significant or lasting effect on the U.S. stock market," notes James Stack, a market historian and editor of InvesTech Market Analyst.

If you own a diversified slice of blue-chip companies, you are drawing earnings from global enterprises doing business on five continents and in dozens of countries. Most disasters that strike one nation -- or even a war that affects a particular region -- aren't enough to slow the steady march of global economic activity.

Stack catalogued hurricanes, earthquakes, environmental disasters, wars, and political crises going back to 1940. He found that in 72% of the cases, equities gained ground within three months of an incident. (Get questions answered by The Help Desk)

One reason investors tend to panic in a crisis is that they didn't think they could lose that much money in a short time. To avoid this surprise, give your holdings a quick-and-dirty "stress test."

Jot down on the back of an envelope how much you hold in each of four basic areas: Blue chips, small caps, foreign stocks, and bonds. Now calculate what you'd have left in each if you saw a repeat of the worst month for each asset, based on index returns since 1970.

That's a 22% loss for blue chips, 31% for small caps, 20% for foreign, and 6% for bonds.

Or simply look back at how you did during the global financial crisis in 2008, says Fran Kinniry, a senior member of Vanguard's investment strategy group.

"If your portfolio was 80% stocks/20% bonds, and it fell 40% in the past and that scares you, you're probably too aggressive to begin with," he says.

Better to make minor adjustments now, when the market is up, than to sell in a panic when stocks are cratering.

It sounds silly, but behavioral science tells us that the act of writing down your plans on paper has a real effect on your ability to stick to a strategy. For example, studies show that smokers who write about their desire to quit are more likely to kick the habit than those who don't.

In this vein, Shlomo Benartzi, chief behavioral economist for Allianz Global Investors, recommends signing a kind of crisis contract.

This is a promise that you would make with your financial adviser -- or your spouse or even a close friend -- about how you plan to act in the event of the next major shock.

"It's good to have a referee," says Benartzi.

Your contract could include triggers for, say, what happens in the event that the market drops a certain amount in a day.

Such documents can't be legally binding, of course. It's your money, and ultimately there's nothing anyone (except maybe your spouse) can do to stop you from panic-selling. But the need to revisit your promises may be enough to calm you down, Benartzi says.

Another tactic: Should you decide to sell, compose a short memo describing the circumstances under which you would reenter the market. Will you buy when the market stops falling for a certain number of days? When it recovers 15%?

This exercise may be tougher than you think -- and that's a good thing. "If you can't outline in detail what your reentry point will be, you might realize that selling is a fruitless exercise," says Mike Scarborough, president of Scarborough Capital Management.

In the face of really bad news, it's natural to feel compelled to do something. Michael Pompian, an investment consultant and author of Behavioral Finance and Wealth Management, says there's a trick that can help you satisfy the urge to sell.

Think of your portfolio as a collection of three buckets:

In your first -- and biggest -- bucket are core holdings such as blue-chip stocks, bonds, and cash.

The next bucket contains assets, like small-cap stocks, that are part of your long-term asset-allocation plan but that might expose you to more risk.

Finally, there's the small chunk of money you have in things that aren't necessary to achieve diversification but that you might be taking a flier on. This high-risk bucket could include shares of individual stocks or a volatile ETF.

If you segment your portfolio that way, you might be able to satisfy your need to sell by simply dumping a stock in your high-risk/high-return bucket.

A fund that offers an all-in-one combination of stocks and bonds can help keep you on an even keel. These include old-fashioned balanced funds, which typically have a steady mix of 60% stocks and 40% bonds; asset allocation funds, which tailor their mix to suit more conservative or more aggressive investors; and target-date funds that steadily move more money to bonds as you approach retirement. (Money 70: Best funds to own)

Such funds offer two advantages.

First, they are likely to have to rebalance to keep to their strategy when the market falls, so they'll buy when everyone else is selling.

Second, choosing one helps you forget any notion that you must decide how much to keep in stocks on a given day. That's the fund's job.

The consultants Aon Hewitt studied the performance of 401(k) participants in the aftermath of the 2008 bear market and found that those who used asset-allocation and target funds did significantly better in 2009 and 2010 than those who didn't.

That's because the first group was more likely to have stayed in stocks during the 2008 slide, says Aon Hewitt's Pam Hess.

Simply signing up for automatic rebalancing in your 401(k) can also help you detach from day-to-day ups and downs. In nervous times like these, it can pay to let go.