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What to do in a stock swoon? Stay calm, rebalance portfolio

Last week, I visited my mother, who raged about greedy corporate executives. I met a WorldCom employee, who had loyally hung on to his shares while the price plummeted. I stayed with an old colleague, who argued you couldn't go wrong with real estate.

Make no mistake, the bear market is causing a lot of pain and a lot of soul searching. By the time I got home from my week's vacation, the market decline had turned into a rout, with the Dow Jones Industrial Average plunging 390 points on July 19 and another 235 points Monday.

What to do? Because I am largely invested in stock-index funds, my portfolio has suffered along with the rest of the market and I don't claim any ability as a market prognosticator. Still, after last week's tumble, I decided over the weekend to make some portfolio changes.

Staying on target: If you want to figure out which way to go, you need to know where you stand. With that in mind, I started by calculating how my portfolio was divvied up between stocks and bonds and between U.S. and foreign shares.

For instance, I aim to have 70 percent of my stock portfolio in U.S. stocks and 30 percent in foreign shares. I can't offer any great rationale for those percentages. I have heard experts recommend as much as 50 percent in foreign stocks and as little as 10 percent.

Instead, I think the key is tenacity, picking target percentages and then sticking with them, no matter what. By last fall, my foreign-stock holdings had fallen well below 30 percent. With some trepidation, I sold U.S. stocks and moved the money into foreign funds.

But last weekend I realized I ought to reverse course. Because foreign markets had held up better than U.S. stocks this year, I needed to lighten up on foreign stocks and move the proceeds into U.S. shares. To avoid messing up next April's tax return, I made the necessary trades in my company retirement plan.

With this "rebalancing," the idea is to keep your portfolio's risk level in check by ensuring the mix doesn't stray too far from your target percentages. But with a little luck, rebalancing should also boost returns, because it forces you to cut back on overheated investments and move the money into sectors that have languished and are due for a rebound.

Despite Monday's trades, my gut tells me that foreign stocks will continue to outperform U.S. shares. But my gut doesn't have a very good track record, so I tend to rebalance whenever my portfolio gets seriously out of whack, even if it seems like the wrong thing to do.

Worrying about rates: When I rebalanced my portfolio, I didn't just fix my mix of U.S. and foreign stocks. I also moved money out of bonds and into stocks.

But as I contemplated trimming my bonds back to their target percentage, that raised a new issue. What sort of bonds should I hold? With 10-year Treasury notes at 4.4 percent, it's hard to imagine interest rates will drop a whole lot further. In fact, I think there's a decent chance that rates will rise and that bond prices, which move in the opposite direction, will fall.

Faced with that threat, I sold some shares of my intermediate-term bond fund and moved the proceeds into the stable-value fund offered in my company retirement plan. Like a money-market fund, a stable-value fund's principal value doesn't fluctuate, so I won't lose money if interest rates spike upward.

Junking junk: In early January, I funneled some savings into a high-yield junk-bond fund, viewing junk as a substitute for stocks. Then, the stock market still looked expensive, and I figured junk bonds had a decent chance of outperforming stocks.

Since then, my junk-bond fund has treaded water, while the Standard & Poor's 500-stock index has plunged 30.5 percent. I have been arguing for years that stock returns are likely to be lower in the years ahead. But as share prices have fallen, the outlook for stocks seems increasingly bright.

I still think junk bonds are a decent bet. But I am no longer confident they will outperform stocks, so on Monday I decided to simplify my portfolio by ditching my junk-bond fund and shifting the money into a Wilshire 5000-index fund.

Seeking solace: Every time you make a trade, you are making a bet that you know more than the market. But the market isn't stupid. Maybe every trade I made on Monday will turn out to be a mistake. Maybe I was wrong to move money into U.S. stocks.

Still, I take comfort in three thoughts. First, when I hear about all the investors who are bailing out of stocks, I think about the buyers. Remember, for every share sold, there's a share bought. There may be lots of folks who foresee nothing but gloom. But there are plenty willing to bet otherwise.

Second, I am banking on well-diversified funds, not individual stocks. Some of the companies in the S&P 500 index may go bankrupt. But it's hard to imagine that S&P 500-index funds will cease to be a viable investment.

Finally, Monday's trades were merely incremental changes. Even if I am wrong, the damage won't be that great. This is not the time for all-or-nothing decisions. You would have to be utterly confident or totally terrified to do that sort of thing. Like they say in the movies: "Everybody stay calm and nobody will get hurt."

_ Jonathan Clements writes for the Wall Street Journal.