How to Keep Your Cool in a Tough Market

Here are some of the key ways that you can do the same.

1. Have a Plan
You can put a lot of time and effort into picking securities, but the stocks and funds you pick probably won't be the key determinant of your long-term return. Instead, the bigger factor will be your asset allocation--your stock/bond mix.

Crafting an appropriate stock/bond mix given one's age, risk tolerance, and years until retirement is a step that, in my experience, many investors skip. Instead, they proceed straight to security selection. As a result, they end up being buffeted around by market winds and could find themselves--as many retirees and pre-retirees recently have--with way too much in stocks and stock funds and commensurately large losses.

Morningstar's Asset Allocator tool can help you get in the right ballpark in terms of your stock/bond split. (Asset Allocator is part of Morningstar.com's Premium service; for a free trial run of the service; click here.) Alternatively, you could buy a target-date fund, or simply crib asset allocations from target-date funds. (David Kathman wrote about how to do that in this article.)

2. Ignore Your Emotions
Knowing that you have a plan can help you tune out the noise and act rationally rather than base decisions on emotion. Right now, for example, with panic in the air, some investors have been pulling their assets out of stocks and fleeing to cash, because that's pretty much the only thing that hasn't gone down. That may buy you some short-term peace of mind, but you'll be left with the nagging question of when to get back into the market. And if you stick with ultrasafe Treasury money markets or CDs, you'll also be saddled with investments that are unlikely to out-earn the inflation rate. Bottom line: The psychologically satisfying course of action is often the least profitable.

On the flipside, investors often pile into a mutual fund or sector after it has already posted huge gains. By the time investors buy into that sizzling fund, it's ready to cool off, usually because the types of securities that it buys are more expensive than they once were and therefore have a lot less room to move up.

If you're going to make adjustments to your portfolio, I would urge you to do so not more than once a year, as part of a regularly scheduled rebalancing plan. And be sure to take a contrarian tack: Lighten up on those areas that have done well, while sending new money to investments that, while fundamentally sound, have not performed as well in absolute terms.

Another tactic for keeping your emotions out of the investment equation is to put your investments on autopilot by investing a fixed sum of money each month. Of course, most 401(k) plans are set up to accommodate a set contribution per paycheck, but you can also invest in many mutual funds using such an approach, called an automatic investment plan. To help screen for mutual funds that offer AIPs, use the "Auto Invest Plan Min Purchase" screen in Premium Fund Screener. (Premium Fund Screener is available to Premium Members of Morningstar.com; for a free trial subscription, click here.)

3. Know That Cheaping Out Doesn't Equal Average
The Bogleheads are a thrifty lot. One of the Bogleheads had arranged for discounted hotel rooms at the conference, while another had secured reduced printing costs for the conference materials. And you know what? The event was just as comfortable and ran just as smoothly as bigger-budget investment conferences that I've attended.

In a similar vein, reducing your investment costs doesn't mean settling for below-average--or even average--results. Because studies have shown that most active managers underperform their benchmark portfolios due to the drag of higher costs, many Bogleheads stick exclusively with ultracheap broad-market index funds, which not only have low expense ratios but tend to have low trading and tax costs to boot. Even if you'd rather pick active funds for your portfolio, it's still worth noting that a low expense ratio is the best predictor of whether a fund will be a good performer in the future. Morningstar's Fund Analyst Picks list is chock-full of cheap offerings, both index and actively managed funds.

4. Save More
The current financial mess we're in is rooted in a simple problem: People were spending more than they had. The lesson that our parents knew and lived--that the way to amass true wealth is to defer instant gratification and save a little bit more every month and every year--seems to have gotten lost along the way.

Of course, life is expensive, whether you're paying for college or your first home or merely filling up your gas tank. It's easy to see why people have a hard time setting money aside each month for saving and investing. But with market returns potentially less impressive over the next decade than they had been in the previous one, investors need to take advantage of all of the sure things they can find. The most surefire way to see that you meet your financial goals is to increase your own savings rate. If you save even $50 extra per month over the next 20 years and are able to earn a 7% return on that money, you'll have more than $26,000 extra at the end of that period.

5. Mind Taxes
I don't know if the bailout will work or if the economy will slump into recession. I don't know what the stock market will do next week or next year. No one does. What I do know, however, is that taxes are here to stay, and the government's recent rescue efforts are apt to put further upward pressure on tax rates.

Savvy investors know that taking steps to reduce taxes, like saving more, is one investment factor that they can influence. Broad-market index funds are favorites among Bogleheads because they tend to be quite tax-efficient, but you can also obtain good tax efficiency with tax-managed mutual funds and by buying and holding individual stocks. Additionally, with the market way down over the past year, the time is right for tax-loss selling; you can use those losses to offset gains in your portfolio and possibly even ordinary income. Finally, it pays to take advantage of all of the tax-saving options available to you. If you believe, like I do, that tax rates could be higher in the future than they are today, Roth IRAs and Roth 401(k)s make a lot of sense. You'll have to pay taxes on your contributions at today's rates, but your withdrawals will be tax-free.

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