Your Crash Plan

By Daniel Kadlec

The only circuit breakers most people care about are the ones in their basement. But there are circuit breakers on Wall Street too, and they've been updated to handle more juice--just in time, apparently, given the electrifying volatility we saw last week. The new breakers are intended to give investors ample time to calm down and think when the market slides 10% or more in a day. But don't wait until that day to consider what you'll do. Take the hint: exchange officials have overhauled their crash plan; so should you.

I'm not suggesting anything dramatic. Patient, long-term ownership of stocks remains a key to financial security. But stock prices are a lot higher than when you started investing, whether that was last decade or last year. The good times may persist until the last baby boomer retires in splendor in 2029. But the market has a history of taking back a good chunk of what it gave--and when you least expect it. Investors got a reminder of that last Tuesday, when the Dow plunged 151 points, part of a four-day drop. It fell an additional 176 points by midday Wednesday, recovered a bit, then fell 70 points Friday.

With economic troubles again brewing in Russia and Asia, think of this week as a second chance to prepare for more pain, possibly something much worse. Even the mutual-fund industry, arguably the biggest beneficiary of perpetual bullishness, is preaching caution. At the industry's recent annual conference, which I attended, the theme was "building investor knowledge." The effort smacks of self-interest; the subtitle might well have been "how fund companies can avoid blame when the bubble bursts." But the basic message--that the market cannot keep going straight up--is a good one. Any stocks or stock funds that you can't hold through a 2000-point Dow slide you should sell now.

What should your overall crash plan be? That depends on your stomach for risk and how long you have before you'll need the money. As a starting point, though, consider lightening your stock allocation, or not investing new money, until you're down to 80% of the stocks you would normally own. That means if you've normally got 75% of your money in stocks, you should go down to about 60% and raise the amount you have in cash and bonds. If the market shoots higher, you'll still enjoy the ride. If it falls, you'll be ready to buy on the cheap.

If you decide to sell some stocks or stock funds now, turn first to your laggards. That will minimize your tax bite. Keep stocks and funds that represent value investments in well-run, established firms whose prices are relatively low as a multiple of earnings and book value. Food, beverage, drug and personal-care companies typically hold up best in market declines.

If the market drops, you'll have the pleasure of picking up some of those high flyers you've wanted to buy but considered--rightly, I think--too expensive of late: the Coca-Colas and Lucents, or the funds that hold them. Do your research and make a shopping list now. Plan to put your excess cash back in stocks in equal steps--as any market drop reaches, say, 8%, 12%, 16%, then 20%. If the market turns around before the final threshold, keep putting money in as those levels are breached going up.

A simpler plan is to rebalance each quarter to keep your desired mix of stocks, bonds and cash steady. That has the salutary effect of forcing you to sell the asset that has risen most and buy the bargains. Today that means swapping stocks for bonds and cash.

Read more of Dan's latest investing advice on time.com and catch him on CNNFN at 12:40 p.m. ET on Tuesdays.