While the stock market has gained back nearly all of its value since it hit bottom in March 2009, and many investors have recovered in terms of rebuilding their portfolios, for some, putting “behind them” the damage their confidence in the stock market has suffered is often much more difficult. Not unlike the experience we have when a good friend’s behavior shatters our trust, we must expect some time to pass before we can again feel fully confident in the stability of the markets.

As the 2008 crisis unfolded, Professor Hersh Shefrin, who teaches behavioral finance at Santa Clara University and the Amsterdam Institute of Finance, commented, “This episode is going to be so painful that 10 years from now we won’t have forgotten.” It is almost four years since the nadir of the crisis, and the economy’s recovery has been slow in coming. So, it is understandable that some have not been able to put this completely “behind” them yet.

Investments are sometimes driven more by emotion than rational calculation, which is the kind of investor behavior that created the tech and housing bubbles. Economist and Yale professor Robert Shiller calls this behavior “wishful thinking bias.” In the 1990s, former U.S. Federal Reserve Chairman Alan Greenspan described it as “irrational exuberance.” It leads to herd behavior–that is, irrational greed during approaching bubbles, followed by what might be called “irrational pessimism” during periods of recovery.

One of the most important things investors must do is prepare their portfolio and psychology for the next period of volatility because, if we know any one thing, the stock market fluctuates, and, along with it, so do our emotional reactions. So, by bracing yourself and not reacting irrationally, that is, immediately dumping what appear at the moment to be overly risky investments, may reap you measurable benefits.

For example: A Fidelity study of retirement account investment behavior showed that participants who kept contributing to their retirement plans from October 2008 to March 2010 and who maintained some exposure to equities throughout the bust-boom period were better off than those who moved in and out of the market.¹ As we often say, if you turned your television off in October 2007 and did not turn it on again until October 2012, you would have thought nothing had happened to the stock market during those five years. As Peter Lynch, architect of the success of the once obscure Magellan Fund, said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

So, how do you prepare for the next financial storm? First, determine your minimum required return to reach your financial goals. Second, make an honest assessment of how you react during periods of high volatility. Third, re-evaluate your portfolio strategy and ensure that your asset allocations provide a level of diversification that suits your risk tolerance, while providing the opportunity to reach and/or maintain your long-term financial goals. Finally, if you do not have the financial expertise to determine these three steps, hire a financial advisor to help you accomplish them.

Simply put, the financial crisis of 2008 was traumatizing. It is likely that the majority of those who held fast and did not succumb to the urge to run for the hills rode the market back up. Like a bad car accident, the memory of 2008 will always be with us, but hopefully we can learn from the experience rather than be fearful every time we get into our car.

¹Fidelity Viewpoints, 7/26/11
Carlo A. Panaccione of Navigation Group is a registered principal with securities offered through LPL Financial, member FINRA/SIPC. California insurance license 0714349. Financial planning offered through Navigation Group, a Registered Investment Advisor. LPL financial representatives offer access to trust services through The Private Trust Company N.A., an affiliate of LPL Financial.