Cold feet in a hot market

(Money Magazine) -- After years of watching stocks go almost straight up, it became pretty easy to forget how temperamental the market can be. Until mid-July, when the subprime mess gave Wall Street its worst scare in nearly five years, stocks were basking in the glow of the second-longest uninterrupted bull run in history.

True, that bull may have gotten a second wind, now that the Fed has slashed a key short-term interest rate to buoy investors and the economy. But stocks don't always go up in a straight line following a Fed rate cut. In fact, they don't always go up.

In three of the past four rate-cut cycles, stocks actually fell in the six months following the first drop in rates. Sam Stovall, chief investment strategist for Standard & Poor's, points out that following the first Fed rate cut in 1990, stocks sank nearly 14 percent. "So you never know," he says.

More turbulence, in other words, is a distinct possibility. And, collectively, investors are heading into this uncertain period with highly aggressive portfolios. Employees in 401(k) plans recently held nearly 70 percent of their accounts in stocks, marking their biggest bet on equities since July 2001, according to Hewitt Associates. What's more, many of those portfolios have gravitated toward some of the riskiest types of stocks.

Now if you can ignore CNBC on a day when the Dow drops nearly 400 points - as it did on Aug. 9 - or not give a second thought to the near-1,200-point drop endured over four weeks, good for you. But if you found yourself checking your investments again and again, or worse, you sold only to start buying after the market went back up in September, it's time to reassess how daring you really are.

Michael Pompian, an investment consultant and author of Behavioral Finance and Wealth Management, says anxious moments like this are "testing periods. Ask yourself, 'Do you still think you're able to stick to your investing plan after a scare like this?' " If not, it's time to dial down your portfolio - before the market does it for you.

Isn't it wrong to let emotions guide your investment decisions? A growing school of thought says it would be a mistake not to factor in your emotional fortitude when assessing how aggressive you should be.

In an article he co-wrote for the Journal of Financial Planning, Pompian argues that sometimes financial advisers need to create an investment plan "that suits the client's natural psychological preferences," even if it means leaving some potential return on the table.

The point is to position your portfolio in a way that makes it less likely that your emotions will get the better of you in a sharp downturn, and to do so while giving up as little as possible of the long-term gains that stocks offer. There are several sensible ways to do that.

After several years of big gains in riskier types of equities, "the average investor is probably overweight emerging markets and small-cap stocks," says Richard Bernstein, chief investment strategist at Merrill Lynch.

By reducing your exposure to these types of stocks, while shifting to more stable investments - like big domestic stocks and shares of blue-chip companies based in Western Europe and Japan - you can maintain your overall equity stake while smoothing the ups and downs in your portfolio.

Remember, investments that soar when times are good also tend to tumble when times turn bad. Case in point: Small-cap stock funds and emerging market equity funds have trounced Standard & Poor's 500 index of blue-chip stocks in recent years.

But during the worst of this downturn, when the S&P lost 9.4 percent between July 19 and Aug. 15, the average small-cap fund tumbled 11.5 percent. And the average diversified emerging markets fund fell even more: 13.5 percent.

For a smoother-than-average ride, you can start by focusing on dividend-paying stock funds to satisfy your large-cap stock allocation. Why? Since 2002, stocks in the S&P 500 that pay out dividends have swayed about a third less than stocks that don't.

Within the Money 70, our list of recommended mutual and exchange-traded funds, one possibility is the iShares Dow Jones Select Dividend Index ETF (Charts). It invests in stocks that not only pay dividends, but that haven't cut payouts in the past five years.

Another option is simply to seek out funds that have a long-term track record of bumping up and down less than their peers. We've done that for you. Within the Money 70, Dodge & Cox Income (Charts), Neuberger Berman Fasciano (Charts), Selected American (Charts), Vanguard Emerging Markets Stock Index (Charts) and Vanguard International Growth (Charts) are examples of funds with relatively smooth, consistent track records.

Sometimes this means these funds won't soar as high during raging bull markets as some of their peers. But on the flip side, a portfolio of them tends to hold up better in difficult markets, and you won't give up much, if any, long-term return.

If you're really having trouble sleeping at night when the market tumbles, you may want to take a more drastic approach by reducing your overall exposure to equities. Certainly, such a move would mitigate potential for losses should the market continue to slide.

For example, by going from an aggressive 80 percent stock-20 percent bond portfolio to a 60-40 mix - and using Money 70 low-risk funds - your worst short-term losses would have been cut in half over the past 10 years.

But such a strategy will also trim your long-term gains. In this case, a 60-40 strategy utilizing the Money 70 funds cost you about 0.3 percentage points a year for the past decade. A 60-40 strategy using average funds would have cost you even more in long-term gains.

That's a steep price to pay for peace of mind. But if you're scared to the point of jumping in and out of the market or shifting your investments to cash whenever stocks take a dive, the bravest thing that you can do is to admit you're not the risk-taker you thought you were. With a little self-knowledge you'll not only sleep better, you'll invest better too.