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Your portfolio: When subprime hits home

The credit crunch has hurt your portfolio, but you can use that squeeze play to your advantage.

By Jeanne Sahadi, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- You're no hedge fund trader or big-time lender, but the subprime mortgage fallout is putting a dent in your portfolio, too.

Since July 19, when the Dow hit an all-time high, value stock funds have fallen over 8 percent, growth stock funds have declined nearly 6 percent, specialty financial stock funds shed 7 percent and real estate funds dropped almost 5 percent, according to Morningstar.

And since mid-May, high-yield bond funds, which are heavily invested in corporate bonds, have fallen nearly 4 percent

But a few months does not necessarily a market make, said certified financial planner Patricia Powell of Powell Financial. "Markets have not fallen off a cliff."

The recent downturn hasn't muted the fact that stocks have provided tremendous gains over the past five years. Since last August, growth stock funds are up 21.6 percent and have an average annual return of 12.9 percent.

Bonds have posted solid gains as well. High-yield bond funds, for instance, have returned 6.5 percent in the past 12 months, and 10.7 percent on an annualized basis since 2002, according to Morningstar.

Powell believes the current state of affairs is a market correction not a bear market, and the trouble is concentrated in the financial sector. That's why she's reducing her clients' exposure to financial stocks. But the move is only temporary, she said, until she feels all the bad news from the lending crisis has finally washed out of financial stocks. She expects to invest more in the sector when the smoke clears.

In recent months, certified financial planner and CFA Gregg S. Fisher, chief investment officer of Gerstein Fisher, has been moving his clients away from long-term high-yield bonds and into shorter-term high-credit-quality bonds.

Powell's advice to investors is to keep their eye on the long term and ride out whatever remains of the current pullback. "We don't have enough information yet[about how exposed banks are to the subprime crisis]. Because of that the market will punish everybody. Financials right now are an unknown risk," she said.

Until that risk becomes better known, here are five things you might do in your 401(k), IRA or taxable brokerage account to minimize the downside potential:

Rebalance your portfolio

If you're like most investors, you neglect your portfolio the way cave men neglect to shave. The run-up in stocks and bonds in the past year has most likely pushed your original asset allocation out of whack.

Consider, too, that today's bad news bears (financial stocks, real estate, corporate bonds and anything else with exposure to mortgage-backed securities) have been among the best performers over the past five years. So while your investments in these areas have been hurt, they're probably still fat relative to the rest of your portfolio.

"It never hurts to rebalance and make sure you haven't let any risks get out of hand," said Russ Kinnel, Morningstar's director of mutual fund research.

But you don't want to pull up stakes altogether. Kinnel suggests keeping at least a modest amount (under 10 percent of your portfolio) in high-yield corporate bonds, since many with exposure to high-quality mortgages may have been oversold. He noted that corporate bonds took a hit when Worldcom and Enron unraveled, but if you'd gotten out entirely you would have missed the rebound. Since Aug. 9, 2002, high-yield funds have had average annual returns of 10.7 percent, according to Morningstar data.

But for your main bond holdings, Fisher recommends sticking to short-term high-quality bonds. If you only have a couple of fund choices in your 401(k), pick the fund with investments that carry the shortest average duration.

Look under the hood

You certainly haven't gone out of your way to invest in funds exposed to subprime loans, but you should check the current holdings of the funds you do own and see if they are lagging their peers or behaving in ways you might not suspect given their asset class.

For instance, high-yield bond funds, which invest primarily in corporate bonds, carry more risk than other bond funds but not so much that a decline of over 20 percent year-to-date is considered normal on the downside. Yet that's been the case for Regions Morgan Keegan Select High-Income Fund (Charts), which had about 15 percent of its portfolio invested in subprimes, said Lawrence Jones, a fixed income mutual fund analyst at Morningstar.

Even Fidelity's Short-term Bond Fund (Charts) and Ultra-Short-term Bond Fund (Charts), which are relatively safe, were lagging their peers because they had a small amount of exposure to the subprime universe, he said.

Take your tax losses

If you have investments in a taxable account, harvest tax losses, Fisher said. For instance, if you have losses in value stocks this summer, you might sell them to capture the loss and reinvest the money in another value investment.

But mind the wash-sale rule, which says in essence if you sell a stock at a loss you will not be allowed to take that loss on your taxes if you buy the same stock 30 days before or 30 days after the sale. If you're selling a fund, you can replace that losing fund with another fund in less than 30 days just so long as it is not the same fund you sold.

Keep some perspective

"Nasty shocks happen regularly," said Russ Kinnel, Morningstar's director of mutual fund research, noting that over time markets have proven resilent.

Indeed, without downturns, you wouldn't see such good returns in the long run, Fisher said. "If you liked the market at 14,000, you should love it at 13,000."

Mind your time horizon

For money you'll need in less than five years, don't risk it on stocks. Keep it in certificates of deposit and money market accounts, Powell said.

For money you'll need in five to 10 years, consider how risk-averse you are. Stocks tend to underperform bonds roughly one-third of the time within a five-year period, Powell said. If you can live with those odds, then keeping a portion of your money in stocks may make sense, she said. If you can't, then stick to less risky instruments.

For investors on the cusp of retirement, here's a look at how you can protect your portfolio from the current turmoil while still allowing for long-term growth in your investments.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.