Ways to Play the Stock Market Now

By Kelli B. Grant
Reporter, SmartMoney.com

For many investors, the past month has been nerve-racking. Sick with inflation fears, the Dow Jones Industrial Average has fallen 7.3% over the past 22 trading sessions since May 10. Over that same time, the Nasdaq has dropped 9.9%.

But as any seasoned investor will tell you, when the market dips, you need to keep your wits about you. While your inclination may be to move to safer havens, that's often not the best move.

Here are five tips on how to manage the market's stormy weather.

1. Keep Dollar-Cost Averaging

Rather than give in to an inclination to sell when the market drops, many cool-headed investors use the opportunity to do a little bargain shopping. (Remember, the idea here is to buy low and sell high.)

If you don't yet have the nerves to take that approach, here's a simple solution: dollar-cost average. By making regular investments over time, you'll avoid buying at a peak. Instead, you'll buy fewer shares when stock prices are high -- and more shares when prices drop. To see how this can offer serious protection during a market downfall, click here.

Contributing to your 401(k) is one of the easiest ways to dollar-cost average. Rather shockingly, nearly 35% of workers who are offered a 401(k) plan at work don't participate, according to the Profit Sharing/401(k) Council of America. That's just foolish -- doubly so, if your employer offers a company match. To see how quickly your 401(k) could grow, click here.
2. Beef Up Your Cash Cushion

If money you need over the short-term is invested solely in the stock market, you run the risk of having to sell when the market is down. That's why you should always have a generous cash cushion at your disposal. It can give you comfort when the market takes a fall -- as well as when life takes some other type of difficult turn, such as a job layoff.

Experts generally recommend that you have three to six months' worth of living expenses on hand for emergencies. The good news: Thanks to the Fed's 16 interest-rate hikes, you can now get a decent yield on money-market accounts. For the best rates, click here.
3. Don't Chase Returns

High-flying stocks and sectors are often the ones hit the hardest when investor sentiment becomes more conservative. Just ask any investor who plowed his or her fortune into tech stocks in early 2000 about how chasing returns can bite you. Despite that, investors have a lemming-like habit of chasing the hottest sectors.

Take a look for a minute at fund flows into the white-hot emerging-markets fund group. Over the past three years, the group has raked up average annualized returns of 37.6%. Investors have looked in the rearview mirror and liked what they've seen: In 2005, an estimated $11 billion flowed into this group, compared with $4.1 billion for 2004, according to investment-research firm Morningstar. And already this year, net inflow is $9.4 billion. Still, by many accounts, the party in emerging markets may be winding down.

"Certainly you can miss out on a rally that still has legs. But you have better chances in sectors where people aren't looking," says Jeff Tjornehoj, a senior research analyst with Lipper. "Be a contrarian. Look for those sectors which have disappointed recently."
4. Find the Right Balance

Being too aggressive -- or too conservative -- is a surefire way to not meet your financial goals. A portfolio that's heavily invested in the hottest stocks or sectors is bound to fall at some point. And on the flip side, one that's purely invested in bonds and cash will likely be heavily eroded by inflation. In other words, you should take a page from 'Goldilocks' and build a portfolio that's just right.

That means diversifying across market capitalizations, geographic region and sectors. To see what's right for you, click here. And for guidance on how to rebalance in today's market, click here.
5. Convert Your IRA to a Roth

"Market downturns provide a golden opportunity to convert your IRA into a Roth," says Ed Slott, CPA and publisher of Ed Slott's IRA Advisor. Thanks to that dip in the market, your investments have a lower value -- which means you'll pay less tax on the conversion than if you had converted during a market high point. "You're sort of getting it on sale," he says.

Here's the deal: When you convert a traditional IRA to a Roth, you will have to pay ordinary income tax (which can run as high as 35%) on any earnings and pretax contributions. That can generate an ugly tax hit, but once the money is held in a Roth, your tax-paying days are over. Roth IRAs grow completely tax free. To see whether a conversion is right for you, click here.

One caveat: You can't convert to a Roth if you file your taxes under the married-filing-separately status, or if your income is greater than $100,000. But don't give up hope completely -- that $100,000 limit is scheduled to expire in 2010. Click here to learn more.

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