How to Make the Best of a Turbulent Market

Investing tip of the month from Morningstar Investment Research Center, by Christine Benz, Director of Personal Finance and Editor of Morningstar PracticalFinance

When it comes to risking your money in the stock market, there's theory, and then there's reality.

In theory, it's much better to be a buyer when the market is down, because you're able to buy more while prices are low.

But when stock prices are dropping further and further by the day, as they have been lately, it's easy to look at the declining values of our portfolios and want to chuck that theory out the window. Even if you're not inclined to retreat to cash, you may find yourself thinking twice about writing a check to your mutual funds. You may also be questioning your investment game plan. You wonder: Do I have enough in bonds? How low can stocks go? And is the fact that stocks have outpaced bonds over very long periods of time indicative of how they're apt to behave in the future?

Here are some tips on what to do--and even more important, what not to do--when the market gyrates like it has over the past several months.

1. Tune out the noise.
The best investors know that the prices of the securities they hold move around a lot more than do the values of the actual businesses. Thus, instead of fixating on how the market is responding to their picks, they concentrate on the picks themselves. If nothing has transpired to alter their holdings' fundamental attractiveness, they don't worry when their portfolios are down, and they often take advantage of price weakness to buy more of what they like.

Even if you don't buy individual stocks, you should take the same approach to managing your own portfolio. If you've crafted a portfolio of investments that makes sense for you given your time horizon and risk tolerance, that same general framework should still apply even after the market has dropped.

2. Focus on what you can control.
Rather than focusing on factors that you can't control--namely, the market's direction--it's empowering to stay squarely focused on those issues that you can.

Make sure that you're confident in your individual-investment selections. If your fund manager is experienced and is employing a sensible strategy, you may find that a down market is an ideal time to add to your favorites, not subtract from them. A link to our Fund (and Stock) Recommendations are located right on the Morningstar Investment Research Center homepage.

You'll also want to be sure that your investment-related costs are as low as they can possibly be. Start by pruning any high-cost mutual funds from your portfolio. If your stock funds are charging more than 1.25% in expenses or you're paying more than 0.75% for any of your bond funds, shop around; you're apt to find cheaper alternatives that can play the same role in your portfolio just as well as the costly offerings do. (International and small-cap stock funds may charge more than 1.25% for their services, but there's almost never a good reason to pay more than 1.5% for any type of fund.)

Don't stop with expense ratios. Managers who trade frequently often rack up high transaction costs; although these trading costs aren't reflected in your funds' expense ratios, they nonetheless can drag on your bottom line. The same goes for taxes, which are really just another form of costs that you can manage if you set your mind to it. To that end, avail yourself of all of the tax-sheltered savings options you can, from 401(k)s to IRAs to 529s, and pay close attention to the types of investments you're putting in your taxable accounts.

Finally, consider ratcheting up your savings rate. If you were to set aside an extra $1,000 a year for the next 20 years, and if that money in turn were to earn a 7% annualized return, you'd add an additional $41,000 to your overall nest egg.

3. Check your time horizon.
If you find yourself wincing over the market's every gyration, it could be an indication that your portfolio is too risky given your time horizon. Conventional financial-planning wisdom holds that you should set aside at least six months' worth of living expenses in a CD or money market fund; you might also consider an ultrashort-term bond fund for this role. Stash any assets that you expect to tap within the next five years in a short- or intermediate-term bond fund, where any fluctuations in your principal value are apt to be quite minor.

4. Avoid "sure things."
Although the broad stock market is down this year, there have been a few tiny pockets of strength. Short-term Treasury bonds have been particularly stable, for example. It's certainly tempting to shift at least part of your portfolio into whatever has been holding up well lately, but think twice before doing so.

For one thing, your portfolio may already have some exposure to that market sector. Moreover, the fact that a security type has performed particularly well during a rough patch for the stock market doesn't mean that it will continue to do so. In fact, many bond-market experts think Treasuries are pricey at this juncture; they're finding much better bargains among high-quality government bonds.

5. Swim against the tide.
Finally, if you must make adjustments to your portfolio amid a falling market, be smart about it. Rather than chasing those pockets of the market that have recently been hot, consider devoting a bigger share of your portfolio to sectors that have struggled lately. You might consider putting fresh money to work in one or more of the value funds in your portfolio, thereby taking advantage of your manager's ability to scoop up some bargains while the market is down. You'll have to hold your nose when adding money to these funds--because most value offerings' recent results have been terrible. Nonetheless, our Fund Recommendations list is a good way to hone in on the most worthwhile funds in the small-, mid-, and large-cap value categories. And if individual stocks have a home in your portfolio, check out Morningstar's 5-star-rated stocks, which have risen to the top of the heap because our stock analysts believe that they're attractively valued right now.

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.