Playing It Safe In A Down Market

As you prepare your home for the wintry months ahead, don’t forget to give your investment portfolio some extra insulation as well.

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Indeed, financial planners say the end of the year marks the perfect opportunity to revisit your asset allocation to ensure it still reflects your financial goals and tolerance for risk—especially with many economists projecting the bear market will continue for the next six months.

"Our internal projections would suggest there’s still risk towards the downside in near-term economic growth," says Joe Davis, chief economist for mutual fund company Vanguard, adding he anticipates continued weakness for "the next several quarters."

Here’s a safe and simple guide to playing a down market.

Getting Defensive

For starters, you’ll want to be sure your portfolio includes some exposure to defensive stocks, or those that provide stable earnings (and often a dividend) regardless of economic conditions.

Also called non-cyclical stocks, the defensive sector includes food companies, consumer staples, pharmaceuticals and utilities—products consumers can’t do without so demand remains constant.

"Defensive stocks are a good core holding for any portfolio in any weather, but might be particularly attractive in times of economic weakness," says Christine Benz, director of personal finance for Chicago-based mutual fund tracker Morningstar, noting companies that exert pricing pressure over their competitors are particularly stable.

For the average investor, notes Benz, "it would not be unreasonable" to have defensive stocks comprise up to a third of their equity portfolio.

Those chasing returns, however, with a larger appetite for risk should remember that while such stocks traditionally provide protection in a falling market, they are rarely high fliers when the bulls take over.

Small But Mighty

While many investors seek out large-cap stocks for stability during a recession, there is evidence that small cap stocks can also help jump start returns when bear markets end.

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A report earlier this year by Ned Davis Research reveals that since 1979 the Russell 2000 small stock index returned 19.6 percent in the first three months after the market reached its bottom compared with 13.6 percent for the large-cap Russell 1000.

At the same time, small caps outperformed their large-cap counterparts for three solid years after the previous bear market ended in 2002.

Here again, however, the message is prudence.

"It’s usually a mistake to try to extrapolate a lot from past down markets since there are different forces at work in every cycle," says Benz. "You can’t use the past as a playbook."

Cash And Bonds

The ultimate safe haven, of course, is cash and bonds.

Savings deposits, money market accounts and Certificates of Deposit (CDs) offer small but certain interest income, plus they’re highly liquid, meaning you can convert to cash quickly if you lose your job or have an immediate financial need.

Bonds, or fixed-income securities, offer their own brand of protection, historically performing well when stocks are in a slide, benefiting from the "flight to quality" among skittish investors.

An added benefit of municipal bonds is that they also offer tax advantages. The interest earned is generally exempt from federal and often state and local taxes, making them highly prized among investors in the upper tax brackets.

Over the last 12 months, however, U.S. Treasury bonds (the safest of all fixed-income securities since they are issued by the federal government) have outperformed munis, says Benz.

If picking individual bonds seems daunting, you can gain exposure to fixed income the easy way by purchasing bond funds, which are professionally managed bond portfolios.

Don't Overdue It

Keep in mind, however, there is such a thing as playing it too safe.

While average investors should have anywhere from 5 percent to 50 percent of their pre-retirement portfolios allocated to cash and bonds (depending on age and appetite for risk), anything more could seriously jeopardize long-term returns.

In part, that’s because the money you tie up misses out on the opportunity for higher returns in the equity market – an opportunity cost.

The other downside to overweighting in cash and bonds is inflation. If inflation rises more than the interest you receive.

Keep It Simple

Rather than trying to time the market, Davis notes it is often more effective to maintain a static allocation of stocks and bonds through good markets and bad—with the ratio determined by the investor’s risk tolerance.

"We would remind investors that it is very difficult to outperform a buy and hold strategy by trying to react defensively," he says. "A lot a lot of our research suggests you’re just spinning your wheels – and that’s before transaction costs."

Indeed, a 2007 study by Vanguard’s Investment Counseling & Research Group reveals that had investors shifted assets to defensive stocks each time the market signaled a recession over the last 30 years they would have just kept pace with the broader market.

In part, says Davis, that’s because bear markets are nearly impossible to predict.

At the same time, defensive stocks are not always, well, defensive.

"Health care at various points in time was actually a growth sector, along with telecom stocks and even consumer staples," he says. "There’s not one sector that has consistently outperformed [the broader market] during bear markets."

In the Vanguard report, bonds were shown to provide greater diversification benefits than defensive stocks in all seasons.

"If you’re thinking about overweighting defensive stocks, we would suggest that a compelling alternative approach is to maintain a small allocation to fixed income," says Davis. "That saves you all the hassle and expense of trying to time these sectors and produces slightly higher risk-adjusted returns."

Easy Does It

Though the bear market has sent many investors running for cover, Benz says, it’s important to remember that this too shall pass.

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Keep your long-term goals in perspective, check your portfolio to be sure it includes some safe havens, and whatever you do, don’t overreact.

Before shifting any dollars in a bear market, investors should look closely at the top holdings of their 401(k)s and Individual Retirement Accounts.

"If you have active portfolio managers, they could be doing things to capitalize on the market environment without you being aware," says Benz. "Before you make preemptive changes, it just makes sense to see where you are and make sure you have an appropriate asset allocation, given your age."

For guidance in that area, Benz recommends investors look to so-called target date funds, which are multi-asset funds that become increasingly conservative as the investor reaches retirement.

And remember, all portfolios should contain a mix of small-, mid- and large-cap stocks, both domestic and international, along with some exposure to fixed income securities.

© 2009 CNBC.com