In normal times, the best advice after a market decline is "Don't be afraid." But these are not normal times, and anyone who is not afraid after a 50% market decline has a few screws loose. The trick is to channel your fear into sensible action that will improve your financial future.
Instead of big impulsive steps you may regret later, you should take small and careful steps that will make you feel you have taken charge. Mental-health experts have found that merely believing you have some control over a painful situation is enough to make the pain more bearable. At a time like this, taking a little bit of action can give you a lot of comfort -- both as an immediate salve for your market wounds today and as a portfolio strengthener in the years to come.
For investors, that means being deliberate in everything you do and making sure that all your decisions are gradual and incremental, rather than sudden and drastic. Call it "smart panic" -- calculated actions that free you from the chains of inertia without compelling you to go haywire.
Normally, inertia keeps investors locked into all their investments, good and bad. As Sir Isaac Newton might have put it, an investor at rest stays at rest, and an investor in motion stays in motion, unless acted upon by an outside force. Severe losses can shock any investor out of inertia, often in destructive ways.
Inventory all your assets. The stock market has lost half its value -- but chances are that when you properly measure the performance of all your investments, you will see that your portfolio as a whole is down considerably less. Use an Excel or Google spreadsheet, even just pencil and paper, to tally up all your cash, bonds, stocks, funds and other investments. Only by taking inventory of everything you own can you tell how well or poorly your wealth has held up. In the process, you will also see -- perhaps for the first time -- how well you are diversified. This advice may seem simplistic, but over the years I have met very prominent investors who actually have no idea what they own. If they could benefit from this step, so can you.
Get an upgrade. By erasing your capital gains, the bear market has taken away much of the tax liability that might have entrapped you in an overpriced mutual fund with an underperforming manager. Now you can ditch it and replace it with what you should have held all along: a low-cost index fund (or if you do not invest regularly each month, an exchange-traded fund). Steve Condon, investment director at Truepoint Inc., a wealth-advisory firm in Cincinnati, points out that this will not only lower your annual expenses and your tax bill, but is likely to raise your return when the stock market does recover. That's because the managers of active stock funds have raised their cash levels to an average of nearly 6% of assets, while index funds always keep all their assets in the market.
Change your new money, not your old money. In your 401(k), you could leave your existing positions in stock funds as they are. Bailing out completely is not the only option for reducing your exposure to stocks. You can take your new contributions from future paychecks and direct them into an investment-grade bond fund. You can always reverse this decision later; to make sure you remember, mark your calendar to review the choice one year from now.
Move your dividends. If you own a stock fund, you aren't obligated to reinvest your dividend distributions in more shares of the same fund. Instead, you can deposit them into a bond or money-market fund. That, says finance professor Meir Statman of Santa Clara University, may be less psychologically painful than having to dump the stock fund in its entirety. "You're turning the dividends into 'fresh money' that doesn't have the taint of loss," he says.
Move on tiptoe. If you can't take the pain of being in stocks anymore, then get out -- an inch at a time. Set up an automatic withdrawal plan with your mutual fund or brokerage account, selling a fixed dollar amount each month for, say, the next five years. Take comfort from the fact that you can stop it, decrease it or raise it at any time. Tiptoeing your way out is a move that's easy and cheap to change. Bailing out of the market in one fell swoop, however, is a step that's difficult and expensive to reverse. Besides the commissions you can face, there's a high psychological cost to the regret you may later incur from any impetuous action.
Sell stocks to erase debts. If you do move money out of the stock market, think first about what you should do with the proceeds. One of the smartest possible uses for the money: getting rid of your credit-card debt. With the interest rates on credit-card balances averaging 10% to 13%, this move gives you what New York City financial planner Gary Schatsky calls "an exceptionally high, guaranteed rate of return." According to the Federal Reserve Board, the median credit-card balance, among families that carry one, is $3,000. The median holding in stocks and mutual funds, on the other hand, was $73,000 in 2007. Let's assume that the value of those investments has since fallen by half, to $37,000. Then selling just 10% of their portfolio of stocks and funds would not only make many families feel better; it could get them out of credit-card debt. (With today's low mortgage rates, credit cards are the liability to attack first.)
Smarten up your cash. Designate the cash part of your portfolio as the "risk-free bucket." That way, you can know that at least one portion of your money will be absolutely safe. Allan Roth, a financial planner with WealthLogic LLC in Colorado Springs, Colo., points out that with inflation approaching zero, five-year certificates of deposits yielding up to 4.5% offer "a very high real return." (You can start your search for them at bankdeals.blogspot.com.) Make sure that the bank or credit union offering the CD is backed by the Federal Deposit Insurance Corp. or the National Credit Union Administration; double-check at www.fdic.gov or www.ncua.gov. Many investors don't realize that the FDIC and NCUA will insure an IRA separately for up to $250,000 if it is invested in a deposit account like a CD. Putting a high-yielding CD in a retirement vehicle is tax-smart, to boot.