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Smart strategies in a scary market

The stock market may seem more risky, but now is a good time to add depressed shares to your portfolio.

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By Michael Sivy, Money Magazine editor at large

(Money Magazine) -- The Dow tumbled last week, and the bad news is spreading. Sectors that haven't been badly affected until now are dropping along with long-troubled groups like the financials.

Technology stocks, for instance, which remained close to a 52-week high until a few days ago, are now down 9 percent from recent peaks.

Concerns are mounting that a recession is already under way and that a bear market is inevitable.

In times like these, it's more important than ever to have a focused investing strategy and to stick with it.

You can destroy your long-term returns by dumping stocks after the worst of a decline is already over and missing the rebound.

And it's equally easy to hurt your returns by going bargain hunting too soon and being blindsided by a second wave of share price declines.

In fact, it's foolish to try to outguess short-term fluctuations. Very few investors can do it consistently enough to beat the market over the long term.

Instead, you should concentrate on positioning yourself to maximize your long-term profits. The good news in today's turmoil is that you'll get plenty of opportunities to buy top-quality stocks at bargain prices over the next few months.

So think carefully about the gaps in your portfolio, and wait for the right opportunity to fill them. The one sure strategy is to wait until share prices are depressed and then buy the stocks you know you want to own.

What's going on

At the moment, we're experiencing the stock market version of a perfect storm, where everything seems to be going wrong at the same time.

That always looks scary, but it also means that an awful lot of bad news is already reflected in share prices.

If you're an optimist, you can take heart from the fact that share prices have held up remarkably well. The daily news is so bleak that you would expect stocks to be down a lot more than 9 percent from recent highs.

And it's possible that current problems are overstated. A weak dollar boosts exports and the overall economy. It's only a problem if it encourages inflation, which so far hasn't happened.

Today's oil price has been bid up a lot by speculators, well above a fair market price. With a slowing economy, we could see the price of a barrel of oil suddenly drop by $20.

Falling home prices and subprime loan defaults are localized and can be absorbed, when compared with the overall real estate market or the total volume of outstanding mortgage loans.

If you're a pessimist, of course, you believe that share prices have a lot further to fall and that many stocks still face whomping losses.

There's no way to tell which view is right. There are really only two things you can be sure of in a situation like this.

The first is that stock prices already reflect all the bad news we know about. The market will fall further only if earnings are even worse than expected, if oil prices keep going up more than expected, or if losses on bad loans are even bigger than expected.

In fact, sentiment is currently so negative that it wouldn't take much good news to spark a rebound.

The second is that no one really knows how bad things are going to get. Federal Reserve chairman Ben Bernanke told Congress last week that the economy is slowing but that it will likely pick up again by Spring.

He acknowledged, however, that it's hard for economists to identify turning points.

If you accept that you can't outguess the market, then it makes most sense to manage down your risk as much as possible and then turn your attention to long-term prospects.

What to consider buying

Traders may have to worry about short-term market risks. But if you're investing for retirement or any other major financial goal that's a decade or more away, you've got a much easier job.

The key ways to minimize your investing risk are well-known ? you've heard them a hundred times before. Buy high-quality stocks and diversify as broadly as you can, owning shares of companies in a variety of industries.

If you don't have enough money to buy lots of individual stocks, consider using index funds or ETFs for specific sectors. They're typically cost-efficient and well diversified.

There are lots of good buys among large, high-quality growth stocks. They have never fully recovered from the tech wreck of 2000-2002. And now that they're dropping along with the Dow, they're getting underpriced again.

The easiest choices for tech investing are two ETFs - Technology Select SPDR (XLK) and iShares Dow Jones U.S. Technology (IYW).

Financial stocks are dangerous to buy until all the bad news is out. But when the troubles end, the best quality banks and brokerages are likely to be great deals.

Historically, financial stocks have dropped for six-to-nine months after a credit crisis developed. That suggests that this decline may not be over until February. That's also a good target date because the banks will have completed their audits for full-year earnings by then.

Attractive ETFs for this sector include Financial Select SPDR (XLF), Vanguard Financials (VFH) or one of the iShares Financials (IYF and IYG).

A smart alternative is to play the financial stocks indirectly, through a high-yield equity ETF. The S&P Dividend SPDR (SDY) tries to match the S&P High Yield Dividend Aristocrats. That index consists of the 50 highest-yielding stocks in the S&P Composite 1500 that have increased their dividends for 25 consecutive years.

Currently, the S&P Dividend SPDR is only about a third financial stocks. Half of the portfolio is split among utilities, consumer goods and industrials. The ETF yields almost 3.3 percent, and that kind of payout provides share price support that couldn't be more welcome. To top of page

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