Stock Basics: When Stocks Head South

Warren Buffett, probably the most successful money manager of the past 30 years, summed it up nicely: The best time to buy stocks is when it's hardest to buy stocks.

If you have a lot of cash, and you're saving for a long-term goal such as retirement more than five years in the future, don't even think of a slump as a bear market. Declines are actually a good time for smart investors to buy high-quality stocks at a discount. So when markets turn south, you should plan to put your money to work, investing a portion of it in stocks every month until your long-term investments are entirely in stocks. Even if they fall some more as bad news buffets the economy, they'll eventually hit bottom—then most likely come roaring back.

If you already dollar-cost average—and that applies to anyone who participates in a company-sponsored retirement program, such as a 401(k) plan—it's imperative that you stick to your guns. You defeat one of the major purposes of systematic investing if you terminate your contributions during a bear market. Investing a fixed amount on a regular basis works because stocks occasionally drop over short periods, but generate superior returns over the long term. A dollar-cost-averaging program, if maintained, forces you to buy stocks when they're on sale.

And remember to rebalance your portfolio just like you would in a bull market, only in reverse. Falling share prices will skew your asset allocation more heavily toward fixed-income securities. So you should regularly—say, once a quarter or twice a year—sell off bonds and money-market funds and invest the proceeds in stocks to restore the desired allocation.

Sell Stocks Gradually

If you're overloaded in one sector or another, sell gradually. Sell a fixed percentage of your stocks every month, so that you're where you want to be in, say, six to 12 months.

If you're fully invested in stocks and you'll need your money in the next couple of years—say, for a child's college tuition—it's likewise time to begin selling. Again, plan to sell a fixed percentage every month. That way, some of your holdings will benefit if the market rebounds down the road.

Call on Uncle Sam

If you're sitting on a huge loss in a mutual fund, consider swapping it for a similar fund. You'll get to declare the loss on your income taxes without jeopardizing your chances to benefit from the eventual recovery.

The plunge in stock prices also gives you an opportunity to tinker with your retirement accounts. Consider converting your traditional IRA to a less-restrictive Roth IRA. With a traditional IRA, you pay your taxes when you withdraw money in retirement—so you'll almost certainly pay higher taxes, because your money will have grown during the time it was invested. With a Roth, you pay your taxes up front. A conversion requires you to pay taxes on the earnings in your traditional IRA, but in a down market those will almost surely be much lower than when the market is booming. (Find out more about Roth conversions.)

Forget Market Timing

Like medical quacks who come out of the woodwork after a patient is diagnosed with a terminal illness, peddlers of market-timing systems do their briskest business when stocks are falling. Unfortunately, no one has ever been able to time the market consistently. You should refrain from this silly exercise. No one really knows which way the market will head next.

The real danger in getting out of the market during a downturn is that you risk missing the start of the next bull market, which may begin explosively.

Spread It Around

During the height of a bull market, the concept of spreading your assets among different types of investments seems quaint, if not obsolete. Nothing like a good, old-fashioned whipping to restore diversification's good name. If you're a long-term investor, put about half your stock money in stocks of large U.S. companies (or funds that focus on that area). Put 25% in foreign stocks, and the final 25% in stocks of small companies. Diversifying among different kinds of stocks will lessen the overall volatility of your investments—that is, how much their value bounces around from month to month and year to year. If you're investing for shorter-term goals, you should have a good portion of your assets in bonds and cash-type investments.