Investors grow leery of stocks in grim market

updated 10:31 p.m. ET Oct. 18, 2008

CHICAGO - Judy Katz reached her breaking point with stocks when the Dow collapsed at the start of this month, free-falling as much as 2,400 points and taking a big chunk of her life's savings with it before she hastily cashed out all of her funds.

Even though she's $200,000 poorer and the market's up 5 percent since she sold, the 65-year-old New Yorker says she is happy to be off the daily rollercoaster — and sure she'll never quite feel comfortable in stocks again.

"I don't know what to do," said Katz, who runs a ghostwriting business, after parking her personal nest egg of nearly $1 million temporarily in her checking account this month. "You can't really put the money under the mattress or somewhere where it will get 2 percent."

Stock prices are back to levels of more than a decade ago, 401(k) retirement accounts have taken huge hits and investors have seen years of savings demolished seemingly overnight. Individual investors have pulled money out of stock mutual funds at a record rate this month — $55.6 billion as of Wednesday, according to TrimTabs Investment Research — amid the 40 percent drop in the Standard & Poor's 500 index since last October.

It is enough to make investors question the soundness of investing in stocks, at least for now, and raises the question of whether older investors in particular could possibly abandon the market for good as many did in the 1930s.

"Just as the Great Depression scared an entire generation away from the stock market, and thereby excluded them from participating in the economy's growth for decades, recent events have the potential to disproportionately taint investors' views against investing," said Barbara MacLeod, professor of finance at Ohio Wesleyan University.

That would mean rejecting the prevailing financial advice to keep some savings in stocks at all ages in order to stay ahead of inflation and earn enough returns so funds are not exhausted in retirement. Historical data make a resounding case for stocks over the long haul, with average returns after inflation of 9.7 percent annually for stocks in small companies and 7.4 percent for stocks in large companies compared to 0.9 percent for "cash" (30-day Treasury bills), according to T. Rowe Price. Consider that so far this year consumer prices have risen at an annualized pace of 4.5 percent.

'Mattress investing'
Numerous experts do not see Americans fleeing stocks for good and heading en masse into "mattress investing" or even CDs or bank accounts — at least not yet.

The reasons, they say: Investors respond mostly to what's happened with stocks in the recent past, meaning a good 12 months could go a long way toward easing the pain of this plummeting market. What's more, though many expect the current economic downturn to be worse than the most recent recessions of 2001 and 1990-91, so far investors have not faced the severe consequences that stem from a prolonged recessionary economy.

Hersh Shefrin, a professor of behavioral finance at Santa Clara University, predicts there will be permanent scarring after the economy hits bottom. That may translate into a more widespread wariness of stocks.

For now, he said, "people have just been sort of jolted and are in a state of some shock. But the scarring's going to happen, I think, because the economic downturn is going to be quite protracted."

The lessons to be drawn from past recessions and bear markets are somewhat mixed, providing some hopeful signs but also worrisome ones with regard to current recovery prospects.

Is there an end to this bear market?
On the bright side are historical numbers that suggest the potential for an imminent end to the bear market, a term generally applied to a prolonged drop in stock prices of 20 percent or more.

The S&P 500 has lost an average of 31 percent during the last six bear markets, which all were paired with recessions. The current, year-old bear market already has exceeded that by 9 percentage points.

But while it takes an average of 3.6 years for investors to break even after a bear market, recovery can take much longer. It took 7 1/2 years for stocks to regain their losses from the bear market that accompanied the 1973-74 recession.

Though financial planners see few signs of investors who are vowing to swear off stocks for good, there are some.

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