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As a survivor of the Panic of 2008, you may well have found yourself lulled into a false sense of security by the market's huge rally throughout much of this year. Yet even a small dip like the one we've seen in the past week or so has reawakened fears of a return to difficult times for stock investors.
What goes up ...
Of course, if any investors really thought that stocks could simply keep going up in a straight line forever, then they were just deluding themselves. Part of the trade-off that the stock market offers is that in exchange for strong returns during good times, you have to be willing to ride out some substantial losses when things go sour. Over time, the ups and downs balance each other out, leaving you with a solid long-term return that's usually higher than what you can get from less volatile investments like bonds and bank CDs.
But it's one thing to understand the risk-return relationship in stocks, and another to be able to withstand risk's full fury. During last year's market madness, lots of investors discovered that they didn't really have as much tolerance for risk as they thought they had. Terrible swings made once-stolid investors lose their confidence and make panicked mistakes -- mistakes that have cost them plenty during the market's rebound.
So if you're wondering what you ought to do in order to preserve the value of your investment portfolio, you have several choices. Here are just a few:
1. Sell stocks you don't believe in
The best time to sell stocks is when their prices are high. Back when the market was in freefall, the most important thing you needed to do was to avoid making emotional, panic-ridden decisions that you would later regret.
At least for now, though, no one's panicking. Stocks aren't anywhere near recovering all of their losses of the past couple of years, but they have bounced quite a way from March's lows. So if you're concerned that economically sensitive stocks like luxury retailer Tiffany (NYSE: TIF ) or construction machine-maker Caterpillar (NYSE: CAT ) aren't good long-term plays, then it's not unreasonable to sell them now. Now that both have doubled from their lows, they certainly don't give you the same margin of safety they offered earlier this year.
2. Buy puts
Another strategy to fend off potential future losses is to buy put options. Puts let you lock in the price at which you'll sell, but they also let you profit if a stock continues to go higher.
The problem with puts is that they're expensive. For instance, with a volatile stock like Bank of America (NYSE: BAC ) , just buying a month's worth of downside protection costs close to 10% of the stock's current price. But depending on how concerned you are about a downturn, that protection may be worth the cost.
3. Cut your risk
Courageous investors have taken advantage of the stock market rally to earn some impressive returns. Even big companies like Freeport-McMoRan Copper & Gold (NYSE: FCX ) and Ford Motor (NYSE: F ) have been multibaggers in recent months, and smaller companies such as Teck Resources (NYSE: TCK ) and Sirius XM Radio (Nasdaq: SIRI ) have had truly stellar performances.
Bear in mind, though, that the companies whose stocks have risen the most -- like the ones above -- were in most cases also among the biggest losers on the way down. So trading out those stocks for more conservative plays may mean missing out somewhat if the market keeps rising, but it should also help give your portfolio some protection from a correction.
Last but not least: Don't do a darn thing
Those three ideas can help you turn a risky portfolio into something that will help you sleep easier at night. But you might not really need them. If you withstood the pounding that the market gave you last year, then you probably have the discipline to stick with your strong stocks when the market heads down again in the future.
Experience is a great teacher, and few have seen an experience like the one we all went through last year. Now, though, you can reap the benefits of your learning -- because now that you know yourself and how you'll react in tough times, you can take steps to anticipate whatever the markets throw your way.
John Rosevear knows when the next crash is going to happen. Read about what he's doing to get ready for it today.