With the intense volatility the markets are experiencing, and economic news looking negative, many investors have been asking if they should sell their equity funds and move to the sidelines until the economic news gets better. History tells us that would most likely be a bad decision that could force investors to miss out on sizeable gains.

The pull of emotions is heavy right now. Even though the market itself isn’t down substantially since its highs of last October, there’s plenty of unsettling news. And the news media keeps holding it in front of our faces.

The list of real and anticipated woes includes recession, inflation, falling real-estate values, political uncertainty – and perhaps most in everybody’s faces right now: rising oil prices.

TIME TO GO TO CASH?

According to the media pundits, this is a good time to move to cash. But before you do that, I hope you’ll take a look at some history.

As you undoubtedly know, the stock market took a thorough beating in 2000, 2001 and 2002, wiping out the fortunes of many previously confident investors.

On Thursday October 10, 2002, the headline of the Money section of USA Today read: “Where’s the Bottom? No End in Sight.” Although nobody knew it then, on the previous day, Wednesday October 9, the Standard & Poor's 500 Index had hit its bottom. Undoubtedly some investors saw that headline, decided that they had had enough … and sold.

On the very day that headline was published, a strong five-year bull market began, during which stock prices more than doubled.

This brings to mind some memorable advice from Warren Buffet: “Be fearful when others are greedy and greedy when others are fearful.”

THE WRONG WAY TO PREDICT THE MARKET

There’s lots of fear afoot these days as people take the pulse of the economy. But history shows us that economic news has been a poor predictor of the stock market. Despite what many people view as “common sense,” the market is often the leading indicator, not the other way around.  This means that the market is trying to anticipate the future, while the economic numbers report the past.

Two important economic indicators in the forefront these days are the unemployment rate and the Federal Reserve’s interest-rate policy. Plenty of experts point to these measures as reasons to buy or sell investments. A popular perception is that when unemployment is rising, the market is likely to fall. Another is that if the Fed is reducing interest rates, that must mean they are worried about the economy slowing down.

Does history say this is a valid way to predict the market? Let’s revisit two pieces of economic news from 2003, when the S&P 500 Index gained 28.7 percent.

• Unemployment was high in 2002 and continued to rise to a peak of 6.6 percent in June 2003, a full nine months after the S&P hit bottom. *

• The Federal Reserve continued cutting interest rates until June 25, 2003, also nine months after the bottom occurred.** 

Investors who bailed out while they waited for better economic news missed a big part of one of the best years in recent history, both for U.S. and international equity funds and for fixed-income funds. Here’s a lesson: When the headlines make it look extremely obvious what you should do with your investments, watch out!

MORE HISTORY: THE 1970s

More history: During the oil embargo and the big market decline of 1973 and 1974, unemployment stood at 6 percent.  In 1975, the S&P 500 Index gained more than 37 percent, even while unemployment figures continued to rise through all of 1975.

In the recession of 1990, the market began its recovery on October 11 that year.  The economic news remained sour through 1991; unemployment continued to climb for the next year and a half, and the Fed continued reducing interest rates. Investors who stayed out of the market because of the economic news missed an important rally.

Time after time, the market has fulfilled its role as a leading economic indicator by rising substantially before economic numbers have improved. For investors with a long-term view, recession and bad news spell opportunity. 

COMPOUNDING THE STRESS

Our emotions, of course, want us to move to cash when the outlook is negative. This may bring temporary relief, but in fact it can just compound the stress. If you rely on your emotions to tell you when to bail out, how will you know when to get back in?

I’ve seen clients wrestle with this as they see economic news finally go positive. By then, the market has often gone up so much that they don’t feel comfortable getting back in. Too many times, they eventually reach the point that they can’t stand to remain on the sidelines while other investors make money. Unfortunately, acting on emotions often leads investors to buy high and sell low.

Fortunately, there’s a better way: discipline. Numerous academic studies have shown that the important decision is carefully selecting the right allocation of equities and fixed income to fit our goals and our ability to tolerate market volatility – and then maintaining that allocation.

This notion is supported by a peer-reviewed paper that is well-known among academics. Published in 1986, the paper by Brinson, Hood, and Beebower found that more than 90% of a portfolio’s return could be explained by knowing its asset allocation.

This means that holding true to your allocation is the most important decision you can make.  It means that timing when to get in and out is far less important.

STAYING ON COURSE

Unfortunately, our emotions don’t care about even the most obvious facts, let alone academic research. That’s why it can be very valuable to have a financial advisor to remind us of how to stay on course.

My colleagues and I firmly believe that the capital markets throughout the world will continue to grow, as they have for hundreds of years, in the face of many incredible challenges.

The best way to take full advantage of that growth is to stay invested in a carefully chosen, globally diversified portfolio that’s designed to meet your needs. You can’t do that if you go to cash.

* See www.bls.gov/

** See www.federalreserve.gov/monetarypolicy/fomc.htm.

Paresh Kamdar is a financial advisor at Merriman