In Uncertain Markets, the 'Right' Response Depends on You

A healthy number of the investing world's greatest maxims relate to the virtues of keeping a cool head in turbulent or uncertain times. There's Shelby Cullom Davis' value-investing mantra, "You make most of your money during a bear market; you just don't know it at the time," and Warren Buffett's all-season exhortation to "Be greedy when others are fearful, be fearful when others are greedy." I'm partial to the lazy investor's credo: "Don't just do something, stand there!," which has applications for investing as well as other parts of life. But such wisdom can ring a little a little hollow in truly uncertain times like the current environment. Every bout of volatility is different, and most of today's investors remember all too well the market slide during the financial crisis, when stocks shed roughly 50% of their value between October 2007 and March 2009. What if the current market volatility is the start of something really bad like that? Further complicating the task of dispensing all-season, all-purpose investing advice is that investors themselves are all different. Those closing in on retirement who haven't looked at their allocations recently may well want to use the current volatility as a wake-up call to lighten up on stocks, despite the frequent admonition to do nothing when stocks are down. Younger investors, meanwhile, should stay the course with the most aggressive equity allocations they can stand, and may even use the sell-off as an opportunity to add to downtrodden stocks. As the current volatility unfolds, here are some ways to ensure that your portfolio doesn't go off track. Don't 'Go Big' Seeing your hard-won portfolio sink isn't pleasant. But at the risk of stating the obvious, it's unwise to retreat to cash with the whole of your portfolio. True, you may buy yourself some short-term solace if the markets continue to be chaotic, but that sense of peace could prove short-lived when stocks recover. When that happens, what had been a sense of calm is usually replaced with the nagging worry about when to get back in, and that can be awfully hard to gauge.

Using the market sell-off as an impetus to scoop up bargains makes more sense, but there's no reason to be anything but deliberate about it. After all, there's no telling whether the election-related uncertainty—and subsequent market volatility--will mark the nadir for stocks in the near term. With stocks not particularly cheap coming into the current turbulence, it's possible that additional—and better--buying opportunities will present themselves in the months or years ahead. Do your homework, pick your spots, and put the money to work over a period of weeks rather than all in one go. Alternatively, you could reasonably delegate the bargain-hunting to a good value-conscious mutual fund or ETF. Let Your Time Horizon Determine Next Steps As you gauge whether to make any changes in light of the volatility, the really important concept to keep on your radar is risk capacity--what sort of losses can you endure without having to rework a goal?

If you still have a reasonably long time until retirement--say, 10 years or more—you have a fairly high risk capacity. That means that regardless of how you feel about near-term losses, you're likely to recover from them during your time horizon. In fact, stocks have generated positive returns in more than 90% of rolling 10-year periods. For that reason, such investors ought to have aggressively positioned portfolios with at least 50% in stocks; given today's low bond and cash yields, a more conservatively positioned portfolio will barely preserve purchasing power, let alone grow. Meanwhile, if you're closing in on retirement or already retired and spending from your portfolio, you have a lower risk capacity. Even if you've been comfy with high equity weightings throughout your investing career, having a too-aggressive equity weighting in retirement can lead to catastrophic losses that would have real implications for your portfolio plan. A soon-to-retire investor who sees her portfolio take a big drop may need to delay retirement, for example, while an already-retired person with big portfolio losses may be forced to give her portfolio withdrawals a big haircut. For too-aggressive investors closing in on needing their money, market drops should actually be a wake-up call to find their way to a more situation-appropriate portfolio mix. Assess Liquid Reserves While plowing a bunch of money into cash during volatile markets is rarely advisable, that's not to say you shouldn't have some liquid reserves on hand as a matter of course. Thus, tough markets can be a good time to check the viability of your cash holdings. (Don't count residual cash holdings in your mutual funds, because you couldn't get access to that money if you wanted it.) Yes, cash yields next to nothing today. But if you're getting close to or in retirement, holding a cash cushion consisting of six months' to two years' worth of living expenses can help ensure that you can cover your household's expenses without having to invade depressed assets. (Note that when I say six months' to two years' worth of living expenses, I'm talking about living expenses not supplied by Social Security or a pension. If those stable income sources are supplying most of your living expenses, your cash stake would be quite small.) That cash cushion is the linchpin of the bucket strategy for retirement portfolio planning. Bargain-hunters at all life stages might also want to use a declining market as an impetus to check up on their portfolios' liquid reserves, so that they'll have ready assets to deploy once they've done their homework. Revisit Your Ballast In addition to assessing your cash holdings, turbulent markets provide a good opportunity to assess your portfolio's ballast. Do you have holdings with the potential to gain--or at least not lose very much--during down markets? I prefer inexpensive, 'vanilla' diversifiers; holding a reasonable allocation in a simple, high-quality bond fund will go a long way toward anchoring a portfolio with sizable equity exposure. This article explores which asset classes have been the most effective diversifiers for equity portfolios. Look Alive for Tax-Saving Opportunities Of course, there's no telling whether the market panic over the election results will prove fleeting or more lasting. If the latter, it's important to remember that a silver lining of market sell-offs is the ability to improve your tax position. Investors in taxable accounts, for example, should be on the lookout for positions that have dropped below their purchase prices; selling such holdings will net tax losses that can be used to offset capital gains elsewhere in the portfolio or, if those gains exceed losses, up to $3,000 in ordinary income. Be aware that you can't rebuy the same security within 30 days of selling it without triggering the wash-sale rule, which disallows you from taking the tax loss. But you can buy a like-minded security—for example, you could sell one bank stock and buy another, or you could sell a bank stock and buy an exchange-traded fund that focuses on banks. In a similar vein, converting Traditional IRA assets to Roth will incur less of a tax burden if executed after markets have fallen, because the taxes due on the conversion depend on the account's value. A tax advisor can help you determine whether it's a prudent time to convert some of your IRA assets to Roth.