Fear and Panic Can Clobber Your Returns

Don’t change your investment strategy based on bad economic news.

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There’s a lot of bad news spooking investors these days. The possibility of a default by Greece could cause a domino effect that might threaten the euro. Will Italy, Spain, and Portugal be next? The economic recovery at home continues at a sluggish rate. The decline in the housing market seems endless.

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These problems pale in comparison to the inability of our dysfunctional Congress to agree on raising the debt ceiling. If the U.S. defaults on its debt obligations, we are in unchartered territory. The rating agencies warn they will lower the triple A rating they give to U.S. Treasuries. Many people believe a default would trigger another recession and possibly a global depression.

What’s an investor to do? How fortunate we are that the securities industry has a solution to this problem. You can purchase mutual funds that protect you against your worst nightmare. According to an article in The New York Times, billions of dollars are invested in these funds. They work by buying options to sell stock or an index at a price below its current level. If share prices fall, these funds make money.

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In an ironic twist, experience with losing money seems to be a big asset for the managers of some of these funds. Boaz Weinstein, who lost more than $1 billion as a trader with Deutsche Bank, has raised $400 million in mostly institutional funds for his new Armageddon fund. Only in the securities industry could this kind of disastrous past performance be marketed as a virtue.

No one knows whether these funds will be good or bad investments. The unpredictability of the stock market is well illustrated by the fact that the DJIA increased by 5.4 percent for the past week, notwithstanding a torrent of bad global economic news. This run-up was contrary to the views of many economists and financial pundits who warned about the possibility of an economic slowdown, or even a double-dip recession, as recently as a month ago.

Long-term historical data indicates that investors who stay the course, investing in a globally diversified portfolio of low management fee index funds in an asset allocation appropriate for them, will do just fine. If you are concerned about the possibility of a global economic disaster, and can’t deal with short-term volatility, it would make far more sense to adjust your asset allocation to a more conservative portfolio, with less exposure to stock market risk.

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Investing in exotic funds with high fees is precisely what the securities industry wants you to do. Encouraging fear and panic generates assets, fees, and commissions for them. It should not be surprising that investing in funds run by managers with experience in losing money is likely to be a losing strategy for you.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.