For investors, the initial shock is starting to wear off after stock markets plunged and fears of a recession spiked over the New Year. What remains is a feeling of anxiety, because subsequent events have done nothing to ease the economic uncertainty that sent stocks tumbling in December and January.
The broad Standard & Poor's 500-stock index moved 1.3% higher in the week ended Feb. 15, but it's still off more than 9% since mid-December.
The U.S. stock market and economy face a period of heightened uncertainty, with an economic recovery, slowdown, and deep recession all possible paths ahead. How should investors react to these troubling times? Here are five tips designed to ease anxieties and prepare you for whatever 2008 brings:
1. Don't get rattled by the uncertainty.
You don't know where the economy or stock market is going, but relax. No one else knows either.
Though almost everyone predicts a slowdown early in 2008, many Wall Street players, including Goldman Sachs (GS), predict a full-blown recession, while Federal Reserve Chairman Ben Bernanke and others believe the U.S. will avoid that fate.
Or look at home prices, which are crucial for determining the extent of our financial crisis. After a long study of 100 metropolitan areas, analysts at Deutsche Bank (DB) estimated Feb. 13 that home prices could fall another 8.1% to 25.7%. That's quite a range.
The bottom line: Trying to bet where the market will go is a fool's errand. It's better to focus on time-tested strategies, such as buying broad index funds using a dollar-cost average strategy.
2. If you trade stocks, be careful how you do it.
The volatility in the stock market these days opens up a major trap for individual investors: Few amateurs can react to news as quickly as the professionals.
One strategy for supposedly dealing with this is limit orders, which allow investors to buy or sell when stocks hit a certain level. But a University of Chicago study recently showed the use of limit orders actually hurts investor returns. Why? When unexpected news breaks on a stock, investors with pre-placed limit orders get a bad deal, because they're often the only orders in the market willing to buy at high prices or sell at low prices that don't reflect the new information.
The bottom line: If you're not a well-informed investor, a volatile market can put you at a distinct disadvantage when you trade stocks.
3. Diversify, and go international.
Most investment advisers say Americans don't invest enough of their stock portfolios overseas. One argument in favor of leaving the U.S. for foreign shores is that many economies are growing much faster than the U.S. Fears of a global recession aside, they're expected to keep that up for the foreseeable future.
Another argument for foreign holdings is the importance of diversification. Investors can get more reward for less risk in a portfolio spread among many different asset classes, including international and domestic stocks, bonds, cash, commodities, and alternative investment strategies.
One caveat: Don't get too fancy. Sophisticated players lost big in the past year's subprime financial crisis, and one reason is that they bought complex investments they didn't understand. If you can't explain an investment in a sentence or two, it might not be right for you.
4. Defensive moves might help you relax, but they'll probably hurt your returns.
Stockpickers tout many strategies for riding out a recession. In theory, sectors including health care or defense will be relatively unfazed by a recession.
Large, international firms are popular these days because so much of their profits come from strong growth overseas.
Chasing these safer bets is a great idea if it helps you sleep better at night. But investors should understand that by reducing their risk, they may also be hurting their return over the long term. A defense stock such as Lockheed Martin (LMT) might hold value in a poor economy. But if the U.S. economy bounces back at midyear, which many expect, the defense contractor is less likely to reap the benefits.
5. Make sure you have enough cash.
The stock market is a great place to make money over the long term. It has a great record of building fortunes after decades of saving and investing. If you're a long-term investor, you don't need to care where the market is right now. Rather, you should care about where stock prices will be five years, 10 years, or more into the future.
The flip side of this advice, however, is that everyone needs a financial cushion for now, just in case. If a major expense hits during a bear market, you don't want to sell your stocks at a loss. That's why all financial advisers say you should keep a substantial amount of cash on hand, probably in money-market funds. How much depends on a variety of factors including the security of your job, your cost of living, and your appetite for risk.
The essential thing to remember is that the economy and market move in cycles, and a steady, sensible approach will carry your portfolio through good times and bad—including Wall Street's current winter of discontent.
Steverman is a reporter for BusinessWeek's Investing channel.