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Fund Spy

Four Ways to Prepare for the Rebound

Things do look dire, but it's possible that the world might not end tomorrow.

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It's hard to think about the good times to come when the stock market is getting pounded day after day. But a savvy investor knows that overestimating the permanence of today's conditions is a dangerous habit. Such reminders typically come when markets are climbing, but the concept is equally important when the atmosphere is dismal.

At some point, the stock market will stage a steady recovery. That could be a long way away; it might arrive sooner than anyone thinks. But a nice, sustained rally is almost certain to come along. That's not just my opinion--you agree! At least those of you who have more than a pittance invested in stocks or stock funds--if you didn't agree, you wouldn't own them, right?

With that in mind, it makes sense to prepare your portfolio accordingly. For a variety of reasons, there's a good chance that your current positioning isn't where you'd want it to be if (I mean, when) the market recovers. Maybe your allocations got out of whack because stocks collapsed; perhaps you've sold holdings to take tax losses and haven't replaced them; maybe you were lucky enough to own stock in  Wal-Mart (WMT) and its stellar performance during the crash has made its weight in your portfolio much, much larger than it used to be.

You don't necessarily have to return your portfolio to its precrash allocations or own the same funds that you did then. Nor do you have to jump in immediately: Encouraging mindless optimism is not the aim here. Rather, the point is this: At a time when our personal investments are the last things that we want to think about, it's critical to force yourself to look them over. Think about what you want your overall portfolio to look like for the long term and remember that that long term will probably include a recovery in the stock market. Then see how closely your current holdings resemble the framework you have in mind.

The Stock Market? Are You Crazy?
The values of all types of stocks have fallen so far, in comparison to cash and most bond funds, that even investors who simply stood pat no longer have the allocations that they once did. Late last week, the S&P 500 Index was down nearly 60% from its October 2007 high. By contrast, cash isn't down at all, and unless you owned the most disastrous bond funds, they held up much better than your stock funds.

As a result, your portfolio probably has a much lower allocation to stocks than it did before the crash. So, take a deep breath and decide if you still want the same allocation to stocks as you used to have. If not, fine--pick a new number. (If you want some assistance in that regard, a recent column by Morningstar's director of personal finance, Christine Benz, provides some hints on how to go about that task.) That will take a bit of thought and effort, but the opposite approach--simply closing your eyes and hoping that things will work out--isn't a reasonable option, tempting as it may be.

A Cash Stash, or Not
A Fund Spy column that appeared on this February noted that many of the top-performing funds during the downturn held fairly substantial cash stakes, and the article asked whether investors would prefer that their portfolio managers were able (and willing) to hold cash at times. A follow-up provided your answers. Many of you indicated that you do want managers to have the flexibility to shift assets out of stocks--perhaps holding huge amounts of cash--if they can't find enough stocks to suit them or if they expect a broad market downturn.

Now's the time to make sure that your funds have the policies you want. When the market rebounds, funds with cash are quite likely to lag. You have to be comfortable with that being the trade-off for protection during declines. If your fund companies' documents don't provide clear explanations of their policies in that regard, call them up and ask specifically how much cash the manager is allowed to own and what the levels have typically been over time. (In many cases the formal limit listed in the prospectus might be fairly high but, in practice, the fund almost always remains almost fully invested.)

The Stronger Stuff
At a time when the S&P 500 has lost more than half its value, it's hard to believe that the index has been an outperformer. But small caps and emerging markets have been battered even worse than the big stocks in the United States and Europe. If you didn't have much exposure to either emerging markets or small caps during this crash, be thankful (though owning them for the five years prior to 2008, when both of those areas outperformed, would have been nice).

However, it's important to think ahead. If you want exposure to emerging markets and small stocks when times improve, you may have to take action. That doesn't mean that you must buy a separate fund for each. Most, but not all, broad international funds have some emerging-markets stocks. Meanwhile, small-cap exposure is less common in most core stock funds, so an all-cap stock fund or dedicated small-cap fund might be needed if you want such exposure.

To be clear, you don't absolutely have to own emerging markets or small caps. But it is essential to know what you want and know what you own.

Time-Horizon Guidelines Are No Joke
Sadly, many people have found out too late the importance of the guideline that stocks, and stock funds, are suitable only for money that they won't need for many years. No one knows exactly how long a time horizon must be to make stocks the right vehicle. But we can be certain that it's extremely risky to put money into stock funds that you know you'll need in a year or two.

So, check your timetables again. Decide how much money you'll need in which time frame, and allocate it accordingly. Of course, stocks could zoom over the next 12 or 24 months, but the chances are too great that they'll decline, resulting in less money in your account than you need for a critical expenditure.

The Good News
Here's a comforting finale: You don't have to be too concerned about the precise numbers.

The fact is, it's incredibly hard to maintain precise weightings. Your overall foreign-stock allocation doesn't depend solely on the money in your foreign-stock funds, it's also subject to the whims of domestic-stock fund managers who are adding or subtracting Nestle or  Toyota Motor  (TM) or  Nokia (NOK). The emerging-markets allocation can similarly vary by a few percentage points, or more, based on a variety of factors, including currency swings, broad-fund managers trading in and out of emerging-markets stocks, or such stocks vastly out- or underperforming others.

Don't worry. There's no telling if your target was exactly right in the first place, so it's not a crisis if your portfolio's allocation levels move a few percentage points off the mark.

The most important thing is to avoid the temptation to simply throw your unopened investment statements into the fireplace. Know what's going on in your portfolio. Give it a structure that you're comfortable with. That approach is likely to be helpful whether the stock-market recovery arrives very soon or is still far, far away.

Gregg Wolper does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.