Should I get out of the market until it returns to sanity?

Planning young: a retirement roadmap
Planning young: a retirement roadmap

I own several stock index funds that were doing well until the market's recent setbacks. I'm afraid that a trade war or some other catalyst will spark a big downturn and I'll lose most of my money. Should I sell and stay out of the market until sanity returns? Or should I just hold on?—Bob

I don't blame you for thinking the market has taken leave of its senses. We've witnessed some crazy swings in stock prices so far this year, with the Dow losing 500 or more points in a single trading session five times, plummeting by more than 1,000 points two of those times. Not to be outdone, the Standard & Poor's 500 index closed 10% or more below its late January peak, not once, but twice.

And if the volatility alone isn't reason enough to question the market's grip on reality, there's stocks' lofty valuations. One widely followed metric, Yale finance professor Robert Shiller's cyclically adjusted P/E ratio, recently hovered around 31 times earnings, or nearly twice its average of 17 or so since the early 1880s. That doesn't mean the stock market is on the verge of collapse. But any time values get this stretched, investors understandably begin to get the jitters.

Still, none of this means mean that dumping your stock index funds — or any reasonably well diversified portfolio of stocks for that matter — is a rational, or particularly effective, response to the market's erratic gyrations.

I'll grant you that it seems possible, even likely, that the market's recent frenetic ups and downs could be a prelude to a nosedive, whether the ultimate trigger turns out to be fear of a trade war, concerns about inflation or rising interest rates or something else. But the simple truth is that we don't really know what lies ahead.

Many times over the course of this nine-year-plus bull market pundits have speculated that stocks' demise may be imminent. And, while there have been some frightening setbacks, so far at least stocks have bounced back and avoided an all-out rout. We know, of course, that the market will enter a full-fledged bear market at some point, as it has done 20 times since 1929. And when that happens we know it's likely stock prices will tumble anywhere from 20% to 50%, if not more. But whether that slide will begin next week, next month, next year or even further in the future no one knows.

Which is why I think it's futile to base your investment strategy on what amounts to speculation. A more sensible approach than trying to divine when you should move in and out of the market is to create a portfolio that you'll be comfortable sticking with in good markets and bad.

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There are two keys to creating such a portfolio. The first is to make sure that you're properly diversified — that is, that the stocks and bonds you own reflect the broad market. When it comes to stocks, that means owning large- and small-company shares, growth and value, and all sectors and industries of the market.

As for bonds, you want to own both government and high-quality corporate issues in a range of maturities (although, to protect yourself against the possibility of rising rates, you'll want to keep the average maturity of your overall holdings in the short- to intermediate-term range).

If you're not sure whether your portfolio is sufficiently diversified, you can plug the names or ticker symbols of your funds or ETFs into Morningstar's Instant X-Ray tool, and you'll see how your various holdings break down by, among other things, asset class, market sector and investing style.

You can assemble such a portfolio on your own with individual stocks and bonds or by combining a variety of different stock and bond mutual funds or ETFs. But you'll be able to achieve the goal of broad diversification much easier by focusing on index funds or ETFs that cover broad swaths of the market.

In the case of stocks, a good example is a total U.S. stock market index fund or ETF, which gives you virtually all domestic publicly traded stocks, while a total U.S. bond market index fund or ETF would essentially give you the entire taxable investment-grade bond market. If you also want to diversify internationally (which I think is a good and easy-to-pull off idea, but not a do-or-die necessity), you can add a total international stock index fund and a total international bond index fund.

The second key to creating a portfolio you can stick with regardless of how the market is performing is to own a mix of stocks and bonds that reflects your tolerance for risk. Basically, you want to have enough of your money in stocks to generate the returns you'll need over the long term to achieve goals like financial security and a comfortable retirement.

At the same time, though, you want to have enough in bonds to provide adequate downsize protection so you don't panic and bail out of stocks during severe market setbacks. (You'll also want to set aside a cash reserve that can cover, say, three to six months' worth of living expenses or, if you're retired, a year to two's expenses beyond what Social Security and any pensions can pay.)

To figure out what mix of stocks and bonds is right for you, you can go to a tool like Vanguard's risk tolerance-asset allocation questionnaire. The tool will recommend a mix of stocks and bonds that's appropriate for you. It will also show you how its suggested mix as well as others have performed in the past.

You don't have to adopt this recommendation exactly. You can simply use it as a starting point, or guide. But if nothing else, answering the questions and seeing how various blends of stocks and bonds have done in good markets and bad in the past should at least be able to help you arrive at a portfolio that's appropriate for your situation.

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Once you settle on mix that feels right for you, you should pretty much leave it alone regardless of what's going on in the market, although you'll need to rebalance periodically to bring your portfolio back to its target allocation. You also probably want to revisit that risk tolerance-allocation tool every couple of years, especially as you near retirement, to see whether your risk tolerance has changed and, if so, reset your target stocks-bonds mix.

I don't want to give you the impression that following this approach will completely shield you from losses when stock prices drop. It won't. You'll still have to exercise the discipline to ride out market setbacks.

But the premise of the allocation strategy I'm recommending is that by limiting the downside to a magnitude you can tolerate, you'll be able to hang on through periods of market turmoil and participate in the eventual recovery. And in the long run, this sort of disciplined strategy should serve you better than guessing when you should exit and enter the market.

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