5 ways to weather market storms

It's hard not to panic when the Dow Jones industrial average drops hundreds of points in a single day, especially when you're depending on stock investments to finance your retirement. But even with the market's recent volatility, there's a case to be made for holding on to at least some stocks for their greater potential returns over the long haul. Here's a checklist to follow so that you can weather the next downturn and enjoy the next bull run.

Have a long-term plan

Your investments should be diversified among stocks, bonds, and cash, based on your tolerance for risk and your time horizon. Make regular investments into each asset over time, regardless of market conditions. Generally, as you get closer to retirement, you should up your bond allocation and reduce your stock holdings. One rule of thumb promoted by Vanguard founder John Bogle: The percentage of your portfolio allocated to bonds and cash should equal your age.

If you don't have such a plan, it's easy to react rashly to daily market gyrations rather than stay on course. Depending on your resources, age, and investment knowledge, you can design your own plan, perhaps using the tools found on many financial-services companies' websites. Or hire a financial adviser to do it for you. We generally recommend that you choose a planner who charges a fee for services rather than one who earns commissions from selling investment products. (You can find tips on how to choose a fee-only financial adviser at www.napfa.org.) An adviser can hold your hand through market downturns and make sure you don't do anything unwise.

Tom Orecchio, a certified financial planner in Westwood, N.J., advises that you disregard the financial news, which is aimed at traders, not long-term investors. "Tune out the noise and focus on the news that you can use long term to improve your financial situation," he says.

Don't sabotage your plan

Buying low and selling high is the goal of any investor, but that can be confounded by the natural impulse to flee to safety in treacherous times. Many investors pile into overvalued stocks and mutual funds at the height of stock surges (such as the Internet bubble of the late 1990s) and then bail out after the market drops. Remember that bear markets are often the best buying opportunities, especially if you're a long way from retirement.

Investors who stay put during volatile stretches might be rewarded for their fortitude. "Unfortunately, you have to stay in the market, as stocks tend to do incredibly well when things look bleak," says Jeff Bogue, a certified financial planner in North Berwick, Maine. "By the time you decide it's OK to get back in, it's too late."

Fidelity Investments recently analyzed the retirement accounts of its participants during the 2008-2009 credit crisis. Those who sold all their stocks during the downturn, whether or not they returned to equities later, didn't fare as well as those who maintained their positions.

Rebalance methodically

Over time, your asset allocation is likely to shift from your desired mix as stocks or bonds appreciate. To set it back on track you have to rebalance—sell investments in the asset classes that are overweighted and buy those that are in the doldrums. It might seem counterintuitive to sell stocks when they're moving higher, but automatic rebalancing takes the emotion out of the decision and forces you to sell high and buy low. Rebalance annually or if your allocation shifts by 3 to 5 percent.

Keep a cash cushion

Cash is king in a recession. If you have enough cash, you won't need to sell stocks during downfalls to cover your immediate needs. A good guideline is to stash enough cash to cover six months of living expenses if you're working and have a secure job and good health insurance; retirees might need one to two years of expenses in cash.

The downside of keeping that much money liquid is that bank savings rates are pitifully low. But don't take risks trying to boost yield, and don't put money into stocks that you might need in the next five years for major expenses such as college tuition, a new car, or a down payment on a home.

Some advisers recommend that you segregate your assets by time horizon, with each "bucket" invested appropriately for when you'll need the money. Al Davis, a certified financial planner in Asheville, N.C., tells his retired clients to keep their emergency cash reserves in an insured bank account or short-term Treasury securities while another bucket holds Treasury bonds of varying maturities and provides enough annual income to cover living expenses. A third bucket would contain a well-balanced portfolio of stocks and bonds for longer-range goals.

Seek the safety of dividends

Stocks in industries that sell products that people need—such as pharmaceuticals, consumer staples, and utilities—usually hold up well during a recession. Those so-called defensive stocks have lower volatility than high-flying tech stocks and generally pay a decent yield. In fact, many companies pay dividends that are more attractive than the 2 percent yield you'll get on 10-year Treasury bonds.

Christine Benz, director of personal finance at the Morningstar investment research company, recommends three no-load mutual funds that invest in defensive stocks: Vanguard Dividend Growth (VDIGX), Yacktman (YACKX), and Dreyfus Appreciation (DGAGX).