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By Christine Benz and Jason Stipp | 08-23-2012 04:00 PM

How to Mentally Prepare for a Volatile Market

Understanding the role of short- and long-term investments, controlling what you can, and adopting a contrarian mindset can help investors mentally weather, and even profit from, a market downturn.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com, and welcome to The Friday Five.

Fiscal cliff woes and ongoing troubles in Europe set the stage for a rocky ride ahead. Joining me to share five tips for handling a volatile market is Jason Stipp, site editor for Morningstar.com.

Jason, thank you so much for being here.

Jason Stipp: Thanks for having me, Christine.

Benz: Well, Jason, we should first acknowledge this a little bit of a turnabout. You usually interview Jeremy Glaser for this segment. Jeremy is out on vacation this week, so I'm going to interview you.

Stipp: Some big shoes for me to fill, but I'll do my best.

Benz: Jason, you have said that one of the most important concepts to bear in mind when you are bracing for a volatile market is that you need to know that this is mainly a mental exercise, not so much an intellectual exercise. Let's talk about what you mean by that.

Stipp: I think as investors you often think about the investment types that you hold, which funds are doing better, how they perform, but that's really just one of the important keys.

The second one is, when you buy and sell those investments. We often see great funds have poor investor experiences, because investors buy at the wrong time and sell at the wrong time, and that really comes down to your temperament. Warren Buffett has said one of the most important, or the most important, quality for an investor is temperament and not intellect, and that's what he's getting at.

Benz: Let's talk about how to come into a potentially volatile period with the right mindset. One of the keys, you say, is asset allocation, and making sure that if you have money that you're going to need to spend within the next several months or even within the next year, you need to have that liquid. Let's talk about that.

Stipp: I think for investors that are approaching that time horizon when they're going to start tapping their portfolios, it's even more critical, and mental errors come even more to bear because they know they're going to depend on that portfolio. They're probably scrutinizing it. And if the market is upset, they are really going to be paying a lot of attention, and I think it creates an environment where poor decisions can be made, and we are all subject to this.

Really the first thing, as you mentioned, is, if you need to tap that portfolio, you want to have a bucket essentially--and you've talked a lot about this and written a lot about it--a bucket that has very safe assets. So these are liquid assets. These are bank savings accounts, money market funds, CDs, potentially for a couple of years out, maybe short-term bonds.

And the thing that these give you, it's really twofold. The first is that these are less volatile assets, so they're not going to be mispriced when the market goes down. They're going to be much more stable. And what that allows you is to know that your short-term needs are going to be covered, so that you don't have to worry about what's going on with those longer-term [buckets] of your portfolio. It gives you that peace of mind to know, hey, the market is going to do something over the next few months, maybe even over the next couple of years. I'm covered for that time period. I'm not going to panic and do a lot of selling out of equities.

Benz: So, you would say this is a good strategy really regardless of market climate that you make sure that you have that liquid bucket.

For the longer-term piece, I think some people might be inclined to say, well, I'm going to take some of that and put more into cash right now. I'm worried valuations aren't all that attractive right now. What about that strategy and what should investors keep in mind as they think about that longer-term growth component of their portfolios?

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