What investors should do now

Rebalance regularly. We called Charles Schwab & Co. investment strategist Liz Ann Sonders looking for some stock-sector suggestions, but all she really wanted to do was preach the gospel of portfolio rebalancing. Sounds dull, we know, but the more we listened, the more we appreciated the timeliness of her advice.

"It's 'Take your vitamins and eat your vegetables,' but it's really the most powerful tool that investors don't use that they ought to," says Sonders.

Sonders considers the 2008 bear market a "wake-up call" for investors who until now have given short shrift to asset allocation and have avoided thinking hard about their appetite for risk. "For example, if you have absolutely no tolerance for a bear-market-type decline" - i.e., a 20% or more move downward - "then you certainly shouldn't have all your money in stocks."

The great advantage to robotically rebalancing your portfolio once a year is that it takes a lot of the guesswork out of investing. "It lets your portfolio tell you when it's time to do something," says Sonders. "It doesn't put you in the position to have to figure out which economist or which strategist is going to be right when he or she says, 'Get out of emerging markets now' or 'Time to buy financials now.'"

Think about it this way. Investors who decided to put 10% of their portfolio in emerging markets five years ago made out like bandits during the multiyear market boom through the end of 2007 in India, China, and other rapid-growth economies. But if they didn't rebalance, by the end of those five years that 10% allocation had ballooned into a much bigger investment, and one fraught with risk. That was especially painful this year, because the Chinese and Indian stock markets fell even further than the U.S. indexes, down 60% and 30%, respectively. A regular rebalancer, by contrast, has taken profits along the way and can now buy back in at a lower price.

Move into munis. If the puny yields on Treasury bonds are getting you down, consider shifting your fixed-income allocation into municipal bonds. Interest income on muni bonds is exempt from federal income taxes (and most state income taxes too, depending on the bond and where you live), which is why the yields on AA- and AAA-rated municipal bonds are usually a quarter of a percentage point lower than for comparable Treasury bonds.

Not so right now. Keen demand for Treasuries from safe-haven-seeking investors is creating an anomaly: The average yield for ten-year AAA-rated munis now stands at 3.96%, vs. 3.80% for ten-year Treasuries, according to Bloomberg. For someone in the 33% tax bracket living in New York, California, or some other place with a high state income tax, that's the equivalent of getting a yield of about 6.50% on a taxable bond.

If you prefer tax-exempt bond funds to individual bonds, a good option is American Century Tax-Free Bond (TWTIX (TWTIX)), an intermediate-maturity fund with a 3.91% yield and a history of steady returns.

Don't lose faith in stocks. By the numbers, there's a case to be made that stocks are historically cheap. But to us, that's more of an argument not to abandon stocks than to go all in. Our advice: Stick with a basic asset allocation: 60% stocks, 30% bonds, and 10% cash. (Obviously you'll need to fine-tune this, depending on age. A 25-year-old should have a much bigger stake in stocks than a 62-year-old, whose top priority should be wealth preservation.)

In any case, the argument for buying stocks is a strong one. With a price/earnings ratio for the past 12 months of 15 and a dividend yield of 2.3%, the S&P 500 is the cheapest it's been in ten years. Indeed, equities look far more enticing than Treasury bonds. The stock market is generally considered to be fairly valued when the earnings yield of the S&P (the inverse of P/E) is on par with the yield on ten-year Treasury bonds. Based on today's yields, stocks look grossly undervalued: The earnings yield of the S&P 500 stands at 6.5%, vs. 3.8% for ten-year Treasuries.

History also offers encouragement for buyers. According to a study prepared by Murray Leith, research director for Canadian investment house Odlum Brown, buying stocks at times of doom and gloom usually pays off. Over the past 40 years there have been eight bear markets in the U.S. In the first full year after the official declaration of a bear market, the S&P 500 returned an average of 12%, better than the 7.5% annualized return over the full 40 years in Leith's study. One disquieting note: The last bear market was an exception. Had you invested in an S&P 500 fund in 2001, you would have lost 22% after two years.

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