Most investors think in exactly the opposite way from how they should. When markets are testing new multiyear highs, as they have lately, they get greedy and think about how much more profit they can squeeze out of their positions. Only when the stock market has fallen substantially do they start thinking about taking protective measures to preserve those profits.
Yet after big upward market moves, the months of September and October have often proven to be turning points for the market. And while smart long-term investors don't necessarily make big changes when markets start getting frothy, what does make sense is to take a critical look at your portfolio and make sure you'd be comfortable with whatever the future may bring. It's a lot easier to figure out how to respond unemotionally to a market decline before it actually comes.
Here are some ideas for your to-do list.
1. Take the right amount of risk
In volatile markets, it's easy for risk levels in your portfolio to get out of whack. For instance, so far in 2012, technology stocks have been far and away the biggest winners, with Apple (Nasdaq: AAPL ) soaring more than 60% even before announcements about a potential new iPhone, the rumored iPad Mini, and other new products. Meanwhile, the utility sector has seen almost no gains at all. You can find similar trends between stocks and bonds and between various international stock markets versus U.S. stocks.
All these swings can leave you with more concentration and higher allocations to risky assets than you want. If you act now, you can take advantage of divergent performance before it reverts back toward the mean, rebalancing to lock in some profits.
2. Have cash ready
Even when bank accounts pay next to nothing, having enough cash is important for a couple of very different reasons. If you rely on your investment portfolio to cover your living expenses, then it's much better to sell off assets when they're expensive to raise cash than to wait until a crash has already happened before selling.
But another reason to get your cash ready is to prepare for better deals on promising investments. Otherwise, you may not be able to jump on deals that won't necessarily last very long. By contrast, having cash on hand will give you the ability to place limit orders now that could automatically execute when prices reach a certain level, guaranteeing you the stock you want at the price you want.
3. Make a wish list
In connection with that last point, it's always useful to have a watchlist of stocks that interest you. But if you haven't done so, go a step further and try to figure out a price you'd be willing to pay.
For instance, despite Facebook's (Nasdaq: FB ) 50% drop, some analysts believe the stock could fall into the single digits, given the potential future selling pressure when its six-month lock-up expires in November. Personally, a $15 stock price would be low enough to catch my attention, although I'd also look for true signs of progress in monetizing its users and content before pulling the trigger.
I'm much more excited about Europe as a long-term play. While many expect the demise of the euro, I still think consumer-oriented companies will survive. So despite their troubles, France Telecom (NYSE: FTE ) and Telefonica (NYSE: TEF ) have enough promise to have me looking closely at current levels, and a slight further drop could be enough to get me to buy.
4. Dump the hard stuff
By contrast, if you own some investments that seem too complicated to understand, now's a good time to get out of them. One example is BP Prudhoe Bay Royalty Trust (NYSE: BPT ) , whose limited lifespan makes the present value of its future dividends worth less than its current share price, at least by some analysts' estimates. Given all the variables involved, it's tough to make reliable estimates of future value. Rather than sweating it, though, selling lets you focus on stocks that are easier to understand.
Do it now
Remember: Thinking about preparing for a downturn does you no good if you procrastinate until the downturn actually happens. Take steps to prepare today, and you'll be a lot happier whenever the next bear market comes.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.