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When a crisis hits, wise investors don't flee the market Add to ...

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

As the euro zone’s slow-motion train wreck inches down the track and Congress bickers over how to tame Washington’s debt problems, many investors have decided to flee the market.

History shows there’s a good chance they’re making a mistake.

To understand why, you need to understand a bit about psychology – especially the human tendency to overreact. Winnipeg-born investment strategist David Dreman has shown that investors tend to be far too eager to sell in times of crisis.

In his 1998 book Contrarian Investment Strategies, Mr. Dreman looked at how the market performed following 11 major crises in the post-Second World War era, including the Korean War, Kennedy assassination, and the first Persian Gulf War. He found that a year after all but one of these crises (the Berlin Blockade being the exception), the market had actually gained ground. The average gain was 25.8 per cent. Two years after the crisis began, the average gain was 37.5 per cent.

For Mr. Dreman, the message was clear: “A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest,” he wrote. “People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower.” His advice: “Buy during a panic, don’t sell.”

Since Mr. Dreman’s book was published, the world has hit repeatedly with bouts of bad news. On Aug. 13, 1998, for example, the ruble collapsed and the Russian stock market lost more than a quarter of its value in a single day. A year later, the S&P 500 was up 22.5 per cent. Two years later, it was up nearly 38 per cent.

Then came the Sept. 11 terrorist attacks. In just five trading days after the attacks, the S&P tumbled 11.6 per cent. Just one month after the attacks, however, the market had gained all of that back.

The next major crisis erupted on Sept. 15, 2008 – the day Lehman Brothers collapsed and triggered the global financial crisis. In this case, the S&P was down about 16 per cent a year later; two years later, it was down about 10 per cent. Not good numbers, to be sure. But remember, following Lehman’s collapse, many pundits were predicting a complete collapse of the global financial system. A 10 per cent drop over two years is a far cry from that.

And that brings us to the euro zone, or more specifically Greece. Its debt crisis boiled over on April 22, 2010, when Moody’s downgraded Greek government debt. Just two trading days later we entered a market correction that was believed by many to be the beginning of another recession. A year after the downgrade, however, the S&P was up about 10.6 per cent; more than a year-and-a-half later, there’s still no recession to be found.

In most or all of these instances, it wasn’t the complete resolution of the crisis that led to the market rebounding. All it took was a bit of light at the end of the tunnel. We’ve seen that recently as the market has jumped on news of plans to deal with the euro zone mess.

So, does this mean that when a crisis hits, you should pour all the cash you have into the stock market? No – such all-in bets come with too much risk for most investors. But I think what it does mean is that when a crisis hits, you shouldn’t ditch your long-term strategy and head for the hills.

The U.S., Canada, and the developed world have been through one crisis after another. Each time, in the face of the most dire predictions, investors who stayed the course did fine.

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