How Do People React When the Stock Market Goes Crazy?

Although the focus at MoneyRates.com is monitoring interest rates on CDs, savings accounts, and money market accounts, for most people these conservative deposits are just one piece of the financial puzzle. Particularly if you're investing for long-term growth, chances are your portfolio will include some riskier assets, such as stocks--especially when bank rates aren't keeping up with inflation.

In light of this, a recent MoneyRates.com/GetRichSlowly.org poll looked at how market volatility in late April and early May 2010 affected attitudes toward stock investments. (By way of background, in the month from April 15 through May 15, there were eight different dates on which the Dow Jones Industrial Average lost 100 points or more.)

The poll asked readers, "How are you reacting to recent volatility in the stock market?" Here were the results:

• Pulling out: I'm diverting more of my money into savings accounts+, CDs, and bonds (12%)
• Putting more into stocks: It's a perfect buy opportunity (32%)
• Riding out the storm: I'm keeping my money where it is (56%)

Which reaction is right? The following are three different schools of thought about asset allocation, each of which could lead you to a different conclusion about how to react to market volatility.

Momentum Investing

Momentum investors believe that it is dangerous to get in the way of the market once it is moving in a certain direction. The logic is that when the market is moving up, it will probably continue to do so for a long period of time, and the same goes for when the market turns down. Under this assumption, once you sense a direction, you go with the flow (i.e., buy if the market is moving up, or sell if the market is moving down) until the direction changes.

There are a couple of problems with momentum investing. First of all, by the time the direction is clear, prices often have already moved against the action you are taking, so it could lead you to buy high and sell low--the antithesis of successful investing. Also, market turns can occur sharply and without warning, so always betting on momentum to continue will be wrong at times.

Fixed-Allocation Investing

Another approach is to set your allocations based on your long-term needs and not to vary them, except to rebalance back to your original targets periodically. This is a steady and consistent approach that can keep you from making short-term mistakes, though it does depend on setting the right target allocation.

Opportunistic Investing

Opportunistic investors try to take advantage of price changes, which can include dips and swings in the stock market. This does not have to mean market-timing--it can be based on a fundamental valuation approach which shifts allocations incrementally as prices change.

Based on the poll results, it seems most people are taking the steady approach of keeping their allocations fixed, though there does seem to be a significant opportunistic component as well. To put recent volatility in perspective, from April 15 to May 15, for all its gyrations, the Dow only lost 4.7%. If losses steepen, perhaps opportunistic investors will become more aggressive--or perhaps more people will push the panic button and start dumping stocks.

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