Smart investors keep their cool - Part 1

With every dip in the stock market, your inner voice urges you to sell. And as the markets become more volatile, the voice gets louder. Here are four reasons to ignore it:

No. 1 Your brain is wired for panic

Don't give in. Professional investors have many clever computer models for assessing risk. But even those brilliant machines misjudge risk from time to time (as in the sub prime meltdown).

How can the rest of us expect to be right about risk when all we have to work with is that carbon-based computer between our ears? Human beings have a hard time thinking about risk in an analytical way. The average person tends to invest strictly by gut feeling.

As behavioural scientists have proven, those feelings are notoriously unreliable in a market like this. Part of the problem is that your brain has evolved to feel the pain of loss more acutely than the pleasure of gain. That means that the normal human reaction in a market downturn is to become fearful and sell-even though risk is lower than it was when stocks were higher and the rational move would be to buy.

Every investor knows that we should "buy low and sell high". But after the market has gone down for awhile, the buy low option may not be emotionally available to most people.

Obsessing over every piece of market news only raises the odds that you'll overestimate risk. The more often you check stock prices, the greater risk you perceive. Prices move up and down constantly. If you're watching minute by minute on your PC or TV, your brain gets the message that it's dangerous out there.

Here is a simple, effective way to lower your anxiety: One study showed that the subjects who perceived the least risk were those who checked their investments no more than once a year.

No. 2 You see safety in the herd.

This is an illusion. Faced with uncertainty, your instinct is to follow the crowd. That is not a good idea. The herd instinct can cloud your judgment. If you see others selling, you'll be liable to ignore your own assessment and sell as well. Economists dub this progression "information cascading." The more cynical of professional investors call it a lemming parade.

In fact, records of mutual fund cash flows indicate that the crowd's investing moves are a reliable indicator of what not to do. Today's fund cash flows suggest that you should buy stocks, since stock funds saw a net withdrawn in January and February, and avoid money markets, which saw multibillion-dollar inflows.

Sure, it's not easy to hang on to equities when everyone around you is bailing, or to avoid buying money markets when others are running for safety. But if you do, history suggests that you won't regret it.

No. 3 You underestimate the risk of avoiding stocks.

These days it's helpful to remind yourself that in the long run the risk of missing stocks' upside poses a graver threat to your wealth than taking hits on the downside. There's no denying that the big one-day drops we've seen recently are no fun, but if you hang in, the math works in your favour.