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A Rational Response to Irrational Market Anxiety

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Market anxiety is good for everyone except you. The financial media loves and stokes it. Readers and viewers increase in uncertain times. The securities industry thrives on it. You flock to them in the mistaken belief they can offer advice and guidance, although the reality is often quite different. Their "expertise" is often a pretense for getting you to take action, which is in their economic self-interest and adverse to yours.

I am not suggesting there isn't cause for concern. Sovereign debt in Europe looks risky. The future of the Euro is in doubt. Iran's nuclear ambitions are edging the world toward a potentially dangerous conflict. Our own recovery is slower than expected. The possibility of a continued slow recovery seems likely. Our national debt is out of control. Our politicians seem incapable of addressing -- much less resolving -- the many economic problems that beset our great country. The nation is more polarized than many have seen it in decades.

All of these issues are fodder for those who have a vested interest in increasing your anxiety to ply their trade. Many of you are asking how these events affect your investing strategy. Unfortunately, you may be asking the wrong people and getting the wrong answers.

I recently put this issue to Mark Hebner, the President of Index Funds Advisors (with whom I am affiliated). I asked him if there was a rational way you could deal with the issue of market uncertainty.

Mark notes that "the function of a stock and bond market exchange is to price risks of economic uncertainty so that investors have a future probability distribution of returns with a positive expected return. The prices set by the millions of traders in the market represent their assessment of current and forecasted risks and the cost of capital associated with those risks."

There is always risk in the stock and bond markets. Risk is the source of returns. The greater the risk, the higher the expected return. Here's an example:

We all know there is a risk that Greece, Italy and Spain may default on their sovereign debt. As that risk level increases, buyers of that debt demand a higher rate of return to compensate them for that risk.

The current price of publicly traded stocks and bonds represents the collective judgment of tens of millions of buyers and sellers, trading about ten billion shares a day. Their judgment is what places a value (the "price") on these shares. It takes into account all levels of economic uncertainty.

When you hear financial pundits discuss economic uncertainty and recommend buying or selling certain assets, you should reject their advice. Whatever facts they are relying on have already been priced into the asset they are recommending you buy or sell. That asset is fairly priced. Trying to find a misplaced asset flies in the face of this basic reality.

Your focus should not be attempting to prove the judgment of millions of traders is wrong. If you succeed, you will be lucky and not skillful. Instead, you should determine your capacity for risk and adjust your exposure to stocks accordingly. Start by taking the Risk Capacity Survey you can find here.

This is a rational approach to dealing with market anxiety. Don't expect to hear this advice from your broker. His advice is most likely rationally related to his self-interest.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of "The Smartest Investment Book You'll Ever Read," "The Smartest 401(k) Book You'll Ever Read," "The Smartest Retirement Book You'll Ever Read" and "The Smartest Portfolio You'll Ever Own." His new book is "The Smartest Money Book You'll Ever Read." The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.