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What experts say: Don't panic!

October 14, 2008 14:50 IST

It's been a bad week on Wall Street. The Dow has been avalanching downward, and the July to September summary of 401(k) statements in people's mailboxes look like black diamond ski slopes.

It's a lousy time to be an investment banker, or a hedge fund manager, or planning a December retirement.

So Forbes.com asked some of the nation's foremost experts in financial crisis what people should do in a moment like this. Their message (and picture this in large, friendly letters): DON'T PANIC.

"Sit still," says Robert Aliber, a professor of international economics and finance at the University of Chicago. Aliber helped write the book on manias, panics and crashes. Literally. He co-authored the most recent edition of Charles Kindleberger's classic Manias, Panics and Crashes which chronicles and anatomizes crashes from tulip mania to the Great Depression to the dot-com bubble.

"By and large what we have is a liquidity crisis," says Aliber. Banks depend more than anyone on the constant availability of credit, and they're in a much worse position than they were a year ago. But should a freezing of liquidity cause a 40% drop for all stocks? A recession would cut into firms' profits but not by that much, says Aliber. That means there are a lot of cheap stocks out there.

In the long term, economists agree. Markets have always recovered in the past. But a famous bit of dismal science wisdom is that in the long term we are all dead. What about in the here and now?

"I would worry about a crash on Monday, but it could also be a huge buying opportunity," says Robert Shiller, the Yale economics professor who wrote Irrational Exuberance and The Subprime Solution and has made much of his career studying bubbles. Even if the majority of businesses are fundamentally OK, that doesn't stop people from overreacting. Irrational exuberance on the way up and irrational panic on the way down are all part of market psychology.

"One question is how big a role patriotism pays in their thinking. You don't want to be part of a market panic," says Shiller. "There's a moral issue in not pulling out."

There's also the issue of not being the sucker who sells at the very bottom of a market.

Stefan Nagel, an assistant professor of finance at Stanford recently co-wrote a paper on this very topic titled "Inexperienced Investors and Bubbles." Harvard's Robin Greenwood and Nagel found that inexperienced investors, in terms of age, are particularly likely to focus too heavily on recent returns.

After the lousy returns of the 1970s, inexperienced investors were more reluctant to invest in stocks. They missed out when stocks returned. After the boom years of the '90s, inexperienced investors were more likely to increase their stock exposure. When the dot-com bubble burst, they got burned.

"We don't have the latest numbers on the current situation yet, but, based on the historical experience, it seems likely that it is particularly inexperienced investors who are rushing for the exit at the moment," says Nagel.

It's another old market maxim, and it's as true on the way down as it is on the way up: Past performance is no guarantee of future results.

In the past four weeks, the Dow Jones industrial average has lost 26% of its value. In the past year, it's lost 40%. And despite comparisons to the Great Depression, the economists who talked to Forbes.com see nothing nearly that severe.

People don't panic forever. And compared with watching CNBC all day, the economists are optimists. That's the pain of being an academic, always the Cassandra: pessimistic when times are good (because there's always a fall coming) and optimistic when times are bad (because things always recover).

But they're not just optimistic because a crisis boosts book sales. "I borrowed money to buy stocks," confides Aliber, with a hint of excitement. "They've lost money since earlier in the week, but I'm going to make a bundle."

Joshua Zumbrun, Forbes.com
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