Honey, I've Shrunk the Portfolio

Your only consolation is that your spouse has forgotten the password to your joint brokerage account.

Over the past year, the S&P 500 is down 9%, and the Russell 2000 small-cap index is down 12%. A number of "widely held" stocks have been hit particularly hard, as the following table shows:

Data from Morningstar as of June 4, 2008.

Investors with concentrated positions in the companies above would have seen their portfolios decline considerably over the past 12 months. And things might not get better any time soon. At the end of May, Warren Buffett commented that he thought we are in a recession that "will be deeper and last longer than many think."

Now, you may want to live in denial about your holdings and hope your spouse doesn't start asking unpleasant questions. Saner investors, however, will want to bolster their portfolios against current market volatility.

Legg Mason's 3 Ds
A recent report from Legg Mason titled "Approaching Volatile Markets With '3-D' Vision" is a great starting point for protecting your portfolio. The authors identified the following three strategies for dealing with topsy-turvy markets:

1. Be diversified.

Legendary fund manager Peter Lynch puts it simply: "Diversification has and always will be a critical component to investing wisely." By diversifying across asset classes -- in equities but also bonds and cash -- you will lower your portfolio's volatility. But you'll also want to diversify within asset classes -- diversification only works when your portfolio's holdings aren't closely correlated. For example, one strategy for the equity portion of your portfolio would be to own large caps and small caps, domestic and international stocks, and even REITs (real estate investment trusts).

2. Be disciplined.

Students and followers of Buffett will recognize the importance of discipline. Discipline -- which is all about your investing behaviors -- looks easy but is nearly impossible to master. To "be disciplined," after all, you'll have to steadfastly focus on the long-term horizon, even when short-term issues garner all the headlines; add new money to the market on a regular basis; and keep emotions out of your buy or sell decisions. Because investing for the long term requires patience, a strong stomach, and an ability to go against the short-term crowd.

3. Be defensive.

Finally, the authors note that buying dividend-paying stocks is a great way to invest defensively in volatile markets. Indeed, they report that 40% of the market's total return since 1926 has come from dividends. In light of current market conditions, the report recommends investing in "strategies focused on dividend-paying stocks."

Not all dividends are created equal
I completely agree that now is a good time to look to add dividend stocks to any portfolio. But which dividend stocks?

When hunting for dividend payers, investors typically look for companies that pay a strong yield while also offering the possibility of long-term capital gains. But make sure you dig beneath that high yield. As James Early, co-advisor for Motley Fool Income Investor, noted, "If you want to feel like an investing loser, buy a stock shortly before it cuts its dividend." Citigroup, for example, sports an attractive yield of 6%, but the company was forced to cut its dividend by 41% earlier this year.

That's not to say that Citigroup will be a bad stock from this point forward. But the market often views a dividend cut very harshly, and a company's shares will suffer accordingly. Chasing yields can be a very costly strategy, so the key is to find quality companies that pay out a healthy and sustainable dividend. As the Legg Mason report noted, "In a market downturn, the sustainability of dividends can serve as a 'vote of confidence' in a company's stability and ability to generate cash flow. It is the ultimate form of corporate transparency."

Honey, maybe you should ask for directions this time
At Income Investor, advisors James Early and Andy Cross look for quality companies that generate enough cash to support their dividend payouts. Avoiding "dividend cut" surprises is a key component of their strategy.

With more than 70 recommendations on the scorecard, the service is beating the market by nine percentage points. If you'd like to harness the power of dividend payers and want to see our team's top picks, we offer a free 30-day trial without any obligation to subscribe.

John Reeves does not own shares in any of the companies mentioned in the article. His wife last checked their brokerage account in 2001. Sprint Nextel is a Motley Fool Inside Value selection. Legg Mason is also an Inside Value recommendation, and the Fool owns shares of it. The Fool has a disclosure policy.