There’s no question that fear moves markets. The devastation in Japan scared many investors not only out of Japanese companies and funds, but also out of the nuclear power industry, insurers, companies with import/export ties to the island nation, and even equity markets on the other side of the planet. Investors don’t like uncertainty and shocks like Japan can trigger bursts of selling. With new reasons to be scared appearing every day, we have to ask: does our fear instinct really protect us?
Fear is big business. Many professional traders and institutions use all sorts of quantitative measures of fear to plot their next trades. The Chicago Board Options Exchange’s VIX, a statistical measure of expected volatility, is considered the benchmark fear index (more about the VIX), but there are plenty of other fear gauges. One clever measure tracks the number of visitors to certain investing websites. More visits mean jittery investors, which means more volatility, which, for some, means it’s time to buy or sell.
Diagram: VIX spikes up on day of Japanese earthquake. Source: Yahoo! Finance
Unsettling events on every channel
Most individual investors ignore the VIX but feel the fear one news report at a time: unrest in Egypt, Tunisia and Lybia, looming default in Greece or Portugal, four or seven dollar gasoline, a stubbornly weak real estate market. It’s easy to find reasons to sell – shaky governments, big recalls, oil spills, high unemployment, terrorist activities, chemical leaks, corruption, natural disasters, invasions, not to mention young Americans in harm’s way in two protracted wars.
Here’s the problem for investors: Bad things happen everywhere, or can happen everywhere. If we sell all holdings where bad things have happened, are happening, or can happen, there’s nothing left to own. Even bonds, gold, and other “safe” investments can be derailed by unexpected events. That leaves passbook savings, mason jars, and mattresses.
Rethinking fear. Many investors see fear as binary – is Japan too risky or not? Stay in or bail? But I believe a more reasonable perspective is this: If I hold a very small portion of my assets – a couple percent, say – in Japan (or Greece, or bank stocks, or real estate) is my financial security in peril if a disaster strikes? Spreading assets across all markets, industries, political systems, and geographies, dilutes the danger associated with any single bad event.
History tells us that markets that tumble after disasters of all kinds often rebound soon thereafter. Investors who bail out after a quick decline may have to buy back in at a higher price. Letting fear dictate investment decisions can be costly. In my view, diversification is a better option. Distributing assets across the market spectrum and around the globe reduces exposure to specific disasters and eases the inclination to flee when bad things do happen.
Is your portfolio fear-proof?