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Rotblut: Five Strategies for Volatile Markets

Charles Rotblut |VP HKSCKPVIamp; Editor, American Ass'n of Individual Investors
Friday, 26 Aug 2011 | 11:17 AM ET

The biggest investment mistakes are often made during market corrections and bear markets.

It is not uncommon for an investor to sell too late into the decline, locking in losses, and then wait for confirmation that rebound is underway, missing out on big gains. (Short-term reversals, like we had earlier this week, often magnify the mistakes by adding to the uncertainty of where stock prices are headed.)

Conventional wisdom suggests that investors turn off their televisions, avoid the financial news and take a deep breath. It's good advice, but I think being proactive is an even better strategy. It is certainly better for those of you who feel the urge to do something. After all, ignoring the market's gyrations is much like dieting: it is easier said than done.

Here are proactive steps you can start taking right now to help weather the market's storm.

Create a shopping list. Market corrections, and particularly bear markets, put many stocks on sale. This makes periods of weakness a good time to look for industry leaders and stocks with good prospects. Write down the price you would buy at if the stock got cheap enough. Monitor the list regularly and if a stock comes close to your target, buy it.

An alternative suggested by Lauren Templeton, of Lauren Templeton Capital Management, is to place limit orders to buy stocks at significant discounts to their intrinsic value (based on discounted cash flow or valuation multiples). If the price falls to your target, the order is executed. As a safeguard, she advises looking for companies with no or low levels of debt. Lauren told me that her great uncle, Sir John Templeton, used this strategy throughout his career.

Sell existing holdings for better ones. One way to free up cash to purchase bargains is to sell stocks you currently own. The goal here is to exchange a current holding for a stock that has more upside potential but still provides diversification benefits. If you have a loss in a stock being sold from a taxable account, you get the added the tax bonus of locking in a capital loss. Just be sure the stock you are buying is truly a better pick.

Rebalance your portfolio. Rebalancing is the process of adjusting your portfolio allocations back to their target percentages. It forces you to buy low and sell high by moving money out of the best-performing asset class and into the worst-performing one. Over time, rebalancing will lower your portfolio's volatility. Vanguard suggests rebalancing when allocations are more than 5% off target, and I think this is a good strategy.

Diversify your bond holdings. Yields on the 10-year Treasury are hovering just above 2%, but there higher yields elsewhere. High-quality corporate and municipal bonds can give you more income without significantly increasing risk. International bonds can also get you higher yields. High-yield bonds (aka junk bonds) do have a role, but only as a supplement to your bond holdings. If you will need the cash in the next couple of years, CDs or money market accounts are also options.

Spend more time researching investment ideas now. Throughout my career, I've seen investors make the mistake of not looking for investment candidates during market corrections and bear markets. This is the opposite of what they should have done. The best bargains are found during bear markets. Even if you don't feel comfortable buying anything today or next week, you should start working on a list of what you would buy if the price was right. (See my first suggestion, "create a shopping list," above.)

History has shown that there are rewards for those who are willing to be proactive when others are fearful. While there is never a free lunch on Wall Street, these strategies will lower your portfolio's risk and increase the chance of profiting from the market's eventual rebound.

How to Identify a Bargain

A stock is a bargain if it has strong fundamentals and is trading at a discount. This means you want companies that are adequately financed, have earnings growth and are trading at low valuations.

I pay particular attention to the price-to-book ratio. This compares a company's market capitalization to the value of its net assets. As I explained in a July 2010 AAII Journal article, a well-managed company trading at or near book value is too cheaply valued and is likely a bargain.

This Week's Gratis Tip

One of the things that separates a bargain stock from one that has merely dropped in price is fiscal strength. Analyzing financial statements can help you separate the strong companies from the mediocre and weak ones.

Rising earnings and moderate levels of debt are important, but so are factors such as intangibles, stock repurchase programs and cash earnings. Frequently Asked Questions About Financial Statements (http://www.aaii.com/classroom/article/frequently-asked-questions-about-financial-statements?a=nm0818) clarifies many of the concepts important to analyzing financial statements.

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Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors (http://www.aaii.com) and editor of the AAII Journal.

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