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By Jeremy Glaser | 09-01-2011 06:10 PM

What (and What Not) to Do During a Volatile Market

Investors should avoid trying to time the market with one big transaction and instead take a staged approach with their buys and sells, says Morningstar's Christine Benz.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. What should investors not do during market volatility? I'm here today with Christine Benz, director of personnel finance, to answer that question.

Christine, thanks for talking with me.

Christine Benz: Jeremy, it's great to be here.

Glaser: So, we have talked about the perils of market timing before, such as trying to get in exactly at the bottom or get in exactly on the top. We recently got some data from Fidelity that really showed kind of perils of that strategy. Can you talk to us a little bit about that?

Benz: Yeah, Jeremy, I think you are right. Investors often do employ that all-or-nothing mindset. So, when things are feeling really panicky, as they have recently with some of these recent 500-point swings in a single day, they are inclined to say, "I'm out of stocks all together." So Fidelity came out with some data a couple of weeks ago that illustrated what 401(k) participants in Fidelity 401(k) plans have experienced, when they have made those dramatic shifts out of equities.

So, the typical Fidelity 401(k) participant who had at least some equities in his or her portfolio, had a 50% gain between October 2008 and the end of June 2011; so that's really good. But people who had made a shift out of equities and stayed out of them had only a 2% increase in their 401(k) portfolios during that time; so that's really dramatic. And even the folks who Fidelity said had gotten out of equities--in which their equity percentages had gone to zero but then they had gotten back into equities--their gains were just half of what the buy-and-hold folks had experienced.

So I think it's a really good example of how investors can undermine their own results with those poor timing decisions. They get out of the market, and it buys them some psychological relief. But when they look back on how their portfolios have performed, they really see that it wasn't worth it because they didn't know when to get back in.

Glaser: But even if investors know they don't want to sell completely out of equities, sometimes it's hard to kind of sit in your hands and do nothing when you see these kind of bold headlines. What should the investor who wants to make some kind of move do then?

Benz: Well, I think there are productive things to do with your time. I always say scout around and see if you are overpaying for investments. Maybe that's the first step. And then also if you are dead set on executing that really big move in your portfolio, you should kind of chicken out and plan to do it over a period of time.

So maybe you want your equity position to go way down, but plan to stage it. Maybe take it down a couple of percentage points over the space of several months and then check yourself. If you still feel like doing that, maybe go forward with it, but chances are you may not feel like executing that big shift.

So, I know it's not the sexiest advice, but I always say if there is almost anything you can do in investing in a chicken way, do it that way versus taking a bold action.

Glaser: Now, when it comes to rebalancing, is that the sort of thing you want to be doing during the volatile markets?

Benz: Well, the recent volatility is just been so extreme, Jeremy. I really think that even though rebalancing is a great part of a long-term investment strategy--so periodically scaling back what's done well for you and adding to your underperformers--I would say during a very volatile time like the one we've just had, you probably want to wait until the dust settles a little bit and wait for your asset allocations to settle down. This is because the risk is of prematurely rebalancing.

You may incur some tax and transaction costs that you otherwise wouldn't need to. You and I were talking earlier about how it feels like we've just been through so much over the past month and yet the market is roughly flat for the year. So you could have made changes over the past couple of weeks to your asset allocation, but ultimately found out that you really didn't need to, and you may have incurred some tax or transaction costs.

I always say concentrate your rebalancing efforts in your tax-sheltered accounts where you won't face those tax penalties to make changes. But in any case, in super volatile times like these, I say just hold off, wait until things settle down, and then think about making those rebalancing moves.

Glaser: Now, thinking about taxes, a popular thing to do might be to try to sell some things on which you'll get tax loss so you'll be able to maybe offset some gains later. Do you think that that makes sense when the markets are moving up 500 points or down 500 points the next day?

Benz: Well, that's another thing. Generally, tax-loss selling I would say is one of the few ways to find a silver lining in a terrible market. So back in 2008 and early 2009, but certainly 2008, we were saying investors should look through their losers and try to get something out of this terrible downturn.

But when things have been quite as volatile as they have been recently, I think it pays to step back and make sure that you are assessing company and fund fundamentals, company specifically. If you are thinking of doing some tax loss selling on individual stocks, you can't get right back into that stock with out triggering a wash-sale rule. So you want to be sure that you truly want to be out of it for fundamental reasons before deciding to push the sell button.

Glaser: And finally, there has been a proliferation of inverse exchange-traded funds and inverse other products to give people the opposite of what the market might be doing. And when you see at the market tanking, it might be somewhat attractive to look at these products. Do you think those make sense during a downturn or during a period of extreme volatility?

Benz: No. I don't, Jeremy. I'm not a fan of these products in any way, shape, or form. They are set up to cater to short-term traders, so the goal of these products is to deliver the inverse or sometimes double the inverse of what a given market index has returned. So the value proposition is if everything is going down, you might be able to capture some upside. But they are designed to do that just for a single day. So, for anyone looking to make any longer-term bet than a single day, they'll really get some perverse effects in the return that they receive. It will not capture the inverse of an index's return over a longer period of time.

So that's one big knock against these funds, the other is the costs. I think the costs are actually really quite high. And frankly, I just don't see what your mainstream investor gets here that he or she couldn't get with a well-laid asset-allocation plan.

Granted bonds aren't going to go way up on days when stocks are going down, but at least you will tend to have kind of that overall smoothing effect. So I just don't see these inverse products having a home in most investors' portfolios at all. I think that they are, as Jack Bogle has called products like these, weapons of mass destruction. They are really not productive for mainstream investors' portfolios.

Glaser: Well, Christine, thanks for your tips today.

Benz: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.

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