Terrorist attacks on New York and Washington, D.C. this month have produced profound shock waves far beyond those cities, and the aftermath could affect the national and world economy for an extended time.

The financial news will continue to be filled with analysis and predictions, but it is impossible to know in advance how events will play out.

But we think a few things worth knowing can be learned from a look at how the financial markets reacted to military and political crises of the past. From this knowledge, investors can figure out what moves are more likely to be productive and what moves are more likely to be counterproductive.

As we are writing this, U.S. financial markets still have not opened. We do not know what their initial reactions will be. But history shows a pattern that has been repeated many times. This particular situation won’t be exactly like any other. But we think the past can give us some useful guidance.

In general, here’s what happens in the aftermath of a crisis. The first reaction is shock. Wall Street hates uncertainty, and nothing creates uncertainty more effectively than a sudden crisis.

The first reaction is typically a “flight to safety,” as investors dump stocks and shift their assets into bonds and cash. Market prices almost inevitably decline. This is so common a reaction that you can practically go to the bank on it. The urge to panic is one of the greatest dangers that investors face. Don’t give in. We are remaining fully committed to our strategies, and you should do the same.

We will predict, because we have seen it happen many times, that most of the investors who sell in panic now will wind up buying back into the market later at much higher prices. This practice may bring some temporary emotional relief, but that relief comes at a high cost. It’s called buying high and selling low.

The second reaction, which usually happens immediately, is increased volatility in commodity markets. Even while U.S. markets were closed, the international markets in gold and oil futures went through spasms.

A third very predictable pattern is overreaction. The first wave of selling is often irrationally broad and steep. Soon after that, investors usually overreact in the opposite direction, sending prices back up.

It never seems this way at the time, but the impact of a crisis itself is a short-term impact. After a few days or a few weeks, calm returns. Investors sort out the probable effects and analysts, by various means, arrive at some sort of consensus view of the future that allows more rational decisions to be made.

These consensus views quite often turn out to be short-sighted, because future events unfold in ways that cannot be predicted. Therefore, another thing history teaches us is that it’s unwise to place too much faith in even the most confident and seemingly obvious predictions. Remember how the energy crisis of the 1970s was going to change the world forever? Remember how the collapse of the Berlin Wall a decade ago was supposed to open a new era of international peace?

This is not to say that today’s crisis is inconsequential. This month’s attacks have produced damage that will require many billions of dollars and many months to repair. Our collective sense of security has been altered, perhaps permanently. Our air transportation system may never again be as relaxed and inexpensive as it has been.

But history tells us that after the initial crisis, the effect on financial markets depends on whether the crisis creates a long-term change in the fundamental nature of the economy. It is – and it will remain for some time – much too soon to know if that is the case now.

One reason you turn to FundAdvice.com is for facts. So let’s look at some facts from history. From a long list of past crises published by Ned Davis Research Inc., we’ve chosen half a dozen, most of which occurred in our lifetimes, to illustrate what has happened in the stock market, in each case represented by the Dow Jones Industrial Average.

For each item on the following list, we show the dates that encompassed the market’s reaction to crisis itself followed by three numbers: the percentage loss on the Dow during that initial reaction, the percentage change one month after the end of the initial reaction and the percentage change six months after the end of the initial reaction.

Ned Davis’ full table lists 28 crises, starting with the fall of France in 1940. On average, the Dow fell 7.1 percent during the crisis, recovered 3.8 percent in the month after the crisis and recovered 12.5 percent in the six months after the crisis. Among those 28 crises, only two (Pearl Harbor and the 1983 U.S. invasion of Grenada) resulted in a lower Dow Jones Industrial Average six months after the crisis.

To sum up history, the typical pattern is this: First there’s a wave of panic selling when the news breaks. Then there’s a short period of instability, followed by an upward bounce once investors realize the crisis itself is not likely to have a long-term effect on the economy.

During a crisis, uncertainty and risk are at their peak. For investors with cash and confidence, opportunity is always greatest when risk is greatest. Remember, investing is a process of deliberately taking risks in the expectation of being compensated for doing so.

We have been asked what we think the markets will make of the current crisis. And we try to be as honest as we can. In times like these, the totally honest answer to any question about the future must be “I don’t know.”

A few of our concerns, the things we’ll be watching, include:

If the recession finally is declared, the result of two consecutive quarters of negative gross domestic product, the news may be better than it seems for investors. Typically, the stock market reaches its bottom when a recession is finally identified. That’s when the risk seems the greatest. And in fact that’s when the opportunities are also the greatest.

Finally, how should investors respond to this crisis? Our recommendations:

Here are two more points. When you re-evaluate your long-term investment strategy, ask yourself how you would invest right now if everything you had was in cash. Remember to think of the long-term effects. You would probably not invest all your assets in cash for the next 10 years, so don’t do it right now.

One final point is very important. If the question on your mind is, “What should I invest in right now?” then there are two answers. The truthful answer has to be, “There’s no way to know for sure.”

However, the overwhelming evidence from the past is that the right answer to that question is, “Invest in many different things.” In other words, diversify.

 

 

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