Investing Tip: How to Profit from Market Volatility

The latest from Morningstar Investment Research Center by Christine Benz . . .

It's been a fun few months, huh? The twin threats of recession and inflation are rearing their heads, the Federal Reserve appears to be, well, a little panicky, and uncertainty reigns supreme. Stocks are soaring one day and sinking like a stone the next, with the bad days far outnumbering the good ones. That has prompted even steely nerved investors to question their game plans.

It's hard to ignore the market's daily gyrations, but paying too much attention to what's going on may prompt you to make portfolio changes that you'll later regret. It may seem like a good idea to put everything into cash until the whole credit crisis blows over. But in so doing you're apt to miss out on some big days for stocks, and you'll also have to wrestle with when to get back into the market.

Instead, focus on things you can truly control. If you must take action, do the following:

1. Check your asset allocation.
If you find yourself worrying beyond all reason about what's happening to your portfolio, that could be an indication that your current portfolio mix is a mismatch for your time horizon and risk tolerance. If you haven't recently checked up on the appropriateness of your asset allocation, that's a good first step in evaluating whether your portfolio is on the right track.
To see where your portfolio stands currently, enter all of your holdings into Morningstar's Investment Research Center's Portfolio tool, then click the View Your Portfolio X-Ray button. You'll be able to see your stock/bond/cash mix, as well as your sector and style-box positioning and your exposure to foreign stocks.

2. Trim investment expenses and tax costs.
Another set of factors that you can control are your investment-related expenses and tax costs. These are unsexy issues that many investors ignore, but paying attention to them is an easy way to improve your take-home return. You can review the average weighted expense ratio of the mutual funds you own by entering them in Morningstar Investment Research Center's Portfolio X-Ray tool. (Remember: These data understate fund costs, because fund expense ratios don't include the trading costs that the fund incurs when buying and selling.) If that figure is much above 1%, you're probably paying more than you should for some of your funds.

For lower-cost options, turn to Morningstar's Mutual Fund Recommendations, which are accessible via the Fund Recommendations link on the home page.

All of our recommendations have been carefully vetted for reasonable expenses, high-quality management and strategies, and shareholder-friendly practices. Also, take a close look at your own stock- and ETF-trading habits. If you're trading too frequently, those transaction costs can also undermine your overall returns.

It's also tax season, which affords a good opportunity to review the tax costs associated with your investments and to make sure that you're taking advantage of any ways to shelter your holdings from Uncle Sam. To the extent that you own securities that kick off a lot of current income, which is taxed at your ordinary income tax rate, consider storing those investments in a tax-sheltered account such as an IRA.

For your taxable accounts, consider making individual stocks, low-turnover stock funds such as index offerings, municipal-bond funds, and tax-managed funds the mainstays. Also, remember that you have until April 15 to make a contribution to an IRA for the 2007 tax year. If you have additional cash on hand, why not make your 2008 contribution at the same time?

3. Check the number of eggs in your basket.
You always hear about the merits of a well-diversified portfolio, and you can see those benefits in action by clicking on the Fund Category link on Morningstar Investment Research Center.
Most stock funds--even international--have been lousy so far this year, but bonds have been rocking the house. Those trends could easily reverse themselves in the months ahead, but those who have taken care to diversify across asset classes and industries have at least muted their portfolio's losses somewhat.

Moreover, the recent travails of Bear Stearns should reinforce the importance of not gorging on your company's stock. A reported 30% of Bear's stock was in employee hands, and Bear's drop from $30 per share to $2 per share in one weekend no doubt inflicted a world of pain on many of these employees' portfolios. I know that it's easy to argue that your company is different/better than ill-starred firms like Bear and Enron. But if you're a big company stockholder, you'll want to ensure that you've augmented those holdings with stocks and funds that give you exposure to other industries.

4. Take a close look at your mortgage.
Even if you weren't speculating in the real estate market or using your home as a piggybank, the housing sector's meltdown still carries some important lessons as well as opportunities for savvy homeowners. In particular, declining or flatlining home values argue for a more aggressive mortgage-paydown schedule than many financial planners have historically recommended. Moreover, the Fed's recent interest-rate cuts may translate into a good opportunity to refinance your current mortgage at a more affordable rate; you may also be able to painlessly reduce the term of your loan at the same time. Ask your mortgage broker to model out what your payments would be if you switched from a 30-year mortgage to one with a 20-, 15-, or 10-year term.

5. Build a strong defense.
Economists seem to be converging around the idea that we're currently in a recession. That argues for building a strong defense. Dust off your resume, cut back on your spending, and also make sure that you have built an emergency fund in case you should lose your job--three to six months' worth of living expenses stashed in ultrasafe securities such as CDs or money market funds. (You'll want to save even more if you have a high-paying job, as it can take longer for highly paid individuals to find a comparably paying position.)

6. Build a strong defense, part II.
Although the Fed seems to be concentrating on the recessionary threat, many economists and market gurus believe that inflation is at least as big a worry as is slowing growth. It's bad enough that inflationary pressures have been ratcheting up our grocery bills, home-heating costs, and the price of refueling our gas tanks. Unfortunately, inflation also has deleterious side effects for your portfolio, because it erodes the future purchasing power of your investment dollars and it also creates a more challenging environment for the businesses you might be investing in. Unfortunately for those looking to protect themselves, there aren't that many places to hide: Inflation hurts both stocks and bonds. Moreover, many of the traditional inflation hedges--such as commodities, Treasury Inflation-Protected Securities, and commercial real estate securities--are arguably pretty pricey.

Despite that generally discouraging picture, large-company stocks, especially those with what we call economic moats and global footprints that give them the opportunity to benefit from global growth, are apt to hold up better in a recessionary environment than smaller company stocks. To help identify such names, use Morningstar Investment Research Center's Stock Screener to find large-cap stocks with Morningstar Ratings of 4 or better and wide economic moats.

7. Look for opportunities.
Last but not least, a lousy market environment always has a silver lining: Some securities are unduly beaten down. Our stock analysts are always on the lookout for high-quality companies that are trading cheaply, and this year's market swoon has nudged some good ones into 4- and 5-star territory. See a list of Stock Recommendations from Morningstar Investment Research Center's main interface.

Morningstar's fixed-income specialists--along with many bond-fund managers--also think that municipal bonds could be trading cheaply right now. That means munis could make sense for you, even if you're not in the highest tax bracket.

Morningstar Investment Research Center is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.