4 Steps and 3 Picks for the Volatility

08/23/2011 8:30 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

Four simple steps will help you weather this kind of volatility while allowing you to strengthen your portfolio, writes Richard Moroney of Dow Theory Forecasts.

Stocks around the world have been hit by panic selling, pushing the Dow Industrials down 15% in three weeks. Here’s what we think you should do now, in four parts:

1. Don’t Panic
If you let emotions like fear, greed, and remorse drive your investment decisions, you’ll always be reacting to the market’s latest swing. In today’s fast-moving markets, you don’t have a lot of time to ponder buy and sell decisions.

But your long-term results are likely to benefit if you carve out some quiet time to deliberate on your investment goals, risk tolerance, and view of the market.

2. Raise Some Cash. With the August 2 bear-market signal under the Dow Theory, we downgraded four stocks and lifted our buy lists’ exposure to a short-term bond fund.

To limit trading commissions, use some common sense and trim selectively, cutting exposure to stocks where your positions are relatively large. Avoid big bets on a single stock or single industry.

We remain comfortable using Vanguard Short-Term Investment-Grade (VFSTX) for our short-term reserves. The fund, yielding 1.6%, has held up well amid the recent market tumult. We’ve trimmed our exposure to stock funds, especially small-company funds, with the proceeds going into bond funds.

3. How Are You Going to React if the Market Takes Another Tumble?
Before betting, good poker players consider what they’re going to do if somebody raises the stakes. Will they be forced to fold? Similarly, you need to consider whether you have the fortitude to weather another decline.

If you think you might panic and sell if the market falls another 10% or 15%, your stock-market exposure is probably too high. Remember, the 24% to 26% bond-fund position of our buy lists is a partial, tactical hedge.

We don’t try to avoid bear markets entirely, partly because all-or-nothing timing is among the best ways to destroy your long-term returns. We are unlikely to ever have less than 60% of our buy lists in stocks, so set your long-term equity allocation with that knowledge in mind.

4. Stay Engaged
While watching the stock market is not nearly as much fun during bear markets, you’re not investing for fun. So, keep looking for buying opportunities and selling opportunities, and strive to limit your portfolio to your best ideas. Relentlessly look for ways to upgrade your portfolio.

Don’t be reluctant to sell a stock just because it is below your purchase price, and don’t be afraid to buy a stock simply because its price might fall in the near term. If you are underweight in equities right now, Apple (AAPL) and IBM (IBM) rank among our top picks.

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