Bumpy market? Stay calm

Key Points

Has recent stock market volatility caught you by surprise? The steady gains over the last several years lulled many into a dangerous complacency. Our wake-up call came on February 27th, when the Dow Jones Industrial Average dropped 416 points, placing it among the Dow's top-10 largest one-day losses. But by mid-April the DJIA made up for that drop. Yet the calmness we experienced for several years is gone; the ups and downs so far in 2007 are likely to continue well into the future. It's normal to worry, but don't overreact and abandon your stocks. Just take these steps to lessen your risk and calm your nerves in the process.

Reduce speculative holdings. What do I mean by speculative? Pretty much anything other than quality bonds or blue-chip stocks. Of course, there are degrees of speculation, and an established small-cap stock could be less volatile than an emerging market holding. In the past, investors have been rewarded with higher returns for taking their chances with these investments. In my estimation, those higher returns have dwindled to the point where the return isn't worth the greater risk. I examine my clients' portfolios for micro-cap stock holdings, small-caps of lower quality, emerging market stocks, and junk bonds that have all grown well beyond their initial allocations. It's time to cash out gains on those high-flyers and devote that money to quality blue chips, which should make up at least half of your equity portfolio. Look for large-cap companies with price-earnings ratios under 20 and 10 percent annual earnings growth. In the new environment we're entering, profit margins will shrink, and 10 percent growth will stand out.

Diversify. Beyond your large-cap holdings, be sure you've diversified into quality small- and mid-cap issues as well as large, broad-based international holdings. While foreign markets have frequently been strongly influenced by US markets in recent years, they now appear to be taking somewhat divergent paths again, and stocks of foreign companies should still hold a firm spot in your long-term portfolio. Even though these two benchmarks correlate closely, the MSCI EAFE index (which measures the performance of stocks in Europe, Australasia, and the Far East) returned a cumulative 101 percent over the last five calendar years, while the Dow Jones Wilshire Composite 5000 Index (which measures nearly all US securities) earned 45 percent. Spreading your risk among established international holdings is always a good bet.

Plan for retirement. I know what you're thinking: "I'm about to retire. I can't bear all the ups-and-downs. Shouldn't I just switch everything to bonds?" Definitely not. When you hit age 65, it doesn't mean that 100 percent of your portfolio should be in conservative fixed-income issues. You may still have a good 25 years of retirement to fund. Market volatility can be unnerving, but a quarter of a century is a long time to sit with low-earning bonds. You shouldn't have your entire portfolio in equities, but a good two-thirds is reasonable. And my advice about selling speculative issues is the same, whether or not you're nearing retirement. Now's the time to sell.