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Show investors a graph of the last 200 years of stock market performance and ask them where the best buying opportunities were.

Every one of them will point to the dips. (And agree that the bigger the dip, the greater the opportunity.)

Now contrast that with the actual behavior of investors themselves during a dip.

Many freeze up and do nothing. The worst panic and sell.

Wall Street is the only market where the customers won’t buy when the merchandise goes on sale.

“I’m getting out and waiting until stocks go lower,” some explain.

Psychologists have a word for this. No, not procrastination. It’s rationalization.

These folks are taking their unspoken fears – that the market will go down and never come back – and turning them into a “practical” reason to run and hide.

If stocks do indeed go lower – as they often do – these investors feel gratified and continue sitting on the sidelines.

When stocks finally turn up, they nod their heads at the pundits and other “experts” who pronounce it a “bear market rally” or a “dead cat bounce.”

Finally, the market goes so high and they feel such regret for missing out that they finally, at long last, get back in.

Before long, the process starts all over again.

The toughest part of investing is not managing your money. It’s managing your emotions.

I’m not suggesting that you’re made of iron and shouldn’t feel fear or excitement or hope or greed. But it’s unwise to act on these emotions.

How do you avoid it?

It starts with knowledge. If you understand how the economy and financial markets work – and how they inevitably disappoint from time to time – you can ride out the occasional rough periods with relative equanimity.

If, on the other hand, you view the stock market as a $30 trillion casino where prices randomly rise or fall, it’s entirely natural to panic when your retirement account suddenly starts wilting like last week’s roses.

Proponents of the “efficient market theory” – the idea that investors understand every bit of public information is already incorporated into share prices – insist that stocks consistently reflect the best estimates of future earnings.

I disagree with this hypothesis. (Not least of all because human beings don’t always act rationally, especially during emotionally charged times.) And, in any event, it’s not the whole story.

The stock market does act like a casino from day to day and even week to week. Individual stocks, whole sectors and even the entire market often gyrate up and down on slight changes in sentiment or outlook.

Why?

Because the fluctuations take place at the margin. On any given day only a tiny percentage of any company’s shareholders are actually selling their shares. (Yet the ones who do set daily prices.)

That’s why it’s laughable to hear the pundits on Fox Business or MSNBC explaining why the market is up in the morning and then down two hours later.

(As if anyone bothered to poll a representative sample of that day’s buyers and sellers and got a statistically valid answer.)

Stock prices are completely unpredictable from day to day. (That’s why day trading is gambling, not intelligent speculation.) It’s only over longer periods that the logic of share ownership emerges.

Given a decent amount of time, share prices follow earnings.

Look back through history and you will not find a single example of a company that increased its earnings quarter after quarter and year after year without the stock tagging along.

Likewise, you will not find a single example of a company with consistently lower earnings whose stock continued to rise, even in a rip-roaring bull market.

Understand this and you’ll know what to do with companies whose shares are down despite their favorable outlooks. (And also what to do with shares that are down because the prospects for the business have worsened.)

The only people who should panic in a stock market sell-off are those who shouldn’t be in the market to begin with.

Who are they?

People who invested in stocks to meet short-term goals like a down payment on a house or a high school senior’s college tuition.

Or folks who are too fearful and anxiety-prone to ride out occasional downturns without capitulating and selling. (Although good luck finding anything that offers the low costs and instant liquidity of stocks with similarly high returns.)

The rest of us – those invested to meet long-term goals and able to buy the dips or at least hang on and reinvest dividends – should take a deep breath and stick with the program.

Just like successful investors have done in every previous downturn over the last 200 years.

Good investing,

Alex

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