Breakevenitis

Story Highlights:

• Earlier this year global stock markets at one point retreated nearly 20% from their October 2007 highs.
• The recent rally has prices nearing breakeven levels for 2008 (though not the highs from last year), tempting investors to sell holdings and recoup losses for fear of a sustained downturn ahead.
• Investors should resist this temptation—selling based on the calendar year or other arbitrary anchoring points will likely lead to underperformance in the long run.

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Whenever markets rebound from a selloff, beware the looming contagion: Breakevenitis is a common affliction known to infect millions of investors each year. Symptoms include sweaty palms, indigestion and a tantalizing temptation to sell securities as they reach their "breakeven" point.

Unfortunately, giving in to this temptation results in a truer sickness: portfolio underperformance. Any portfolio decision based on an arbitrary level like a breakeven value is always and everywhere an emotional reaction—a reincarnation of the hysteria that fuels corrections and subsequent rebounds. Short-term, emotion-based decisions inevitably lead to lower performance over time.

Framing and anchoring are among the most common cognitive biases in investing. Both are about seeking context. Human brains can't do much with data in a vacuum—they constantly seek surrounding information to make things seem more intelligible. Investors naturally use the calendar year as an "anchor" in order to "frame" (or give context to) market movements. While that might be natural, it can also get you into a lot of trouble.

The truth is past market movement (by itself) isn't predictive of future moves. Thus, stock charts, which by definition are an accounting of history, tell you little or nothing about the future. That the market was down 10%, 15%, or even 20% in preceding months is no harbinger of the months to follow. The market could continue downward, or it could reverse course and shoot sharply upward.

Markets are similarly fickle during rallies too. Regardless of whether they've been up or down of late, their movement alone has no implications for investors. For example, markets experienced several double-digit drops during the 1990s bull market. Each time, they quickly rebounded to new highs. Why? Because too-dour sentiment and better than appreciated fundamentals ultimately pushed the market higher. Investors who pulled out as they broke even likely missed out on substantial returns. Such a reaction to volatility typifies how emotional decisions often conflict with a prudent long-term investment discipline.

For most investors with a long time horizon, short-term fluctuations amid a larger bull market only matter if accompanied by a malady (like Breakevenitis) which tricks them into selling. There are many reasons not to sell stocks at an arbitrary point, trading costs among them, but the big one is the risk of missing a significant run-up. Remember, missing only a handful of the best days of any bull market will cause substantial underperformance over time. This is why investors should exit markets only (if at all) when they have corroborating, widely unappreciated fundamental data supporting their decision.

So in the meantime, get some rest and take care of yourself. The best cure for Breakevenitis is to avoid it in the first place.