Short-Term Investing in a Bear Market

My portfolio is down 33% and my investment horizon is three to 10 years. Should I sell now or pray the market recovers?

QUESTION: I started investing in mutual funds in 1998, and my portfolio is now down 33%. Should I take my money out and put it in something more secure, or gamble on the market going up in the future? My time horizon is three to 10 years.

ANSWER: We hate to point out the obvious, but you're not exactly in an enviable position right now. If your investment horizon isn't especially flexible -- meaning you're going to need at least some of the cash in as little as three years -- then part of your portfolio needs to be invested conservatively. But selling into this market is a losing proposition, since you'll be locking in your losses and will have little chance to recover what you've lost so far.

What to do? First, consider your timeline. Do you absolutely need your money in three years? If so, you're facing some painful decisions. Your scenario is decidedly better, however, if you could put off your goal for a few more years. (For example, if you're saving for a down payment on a house rather than, say, your oldest child's upcoming college bills.) If you're able to push back the deadline, you can create a large enough window to ride out some market gyrations while also properly repositioning your portfolio for future needs. (If that's the case, use our Asset Allocator to help determine how to rebalance your investments.)

Fact is, anyone with an investment horizon of less than five years needs to strategically shift their investments into more conservative savings vehicles as their deadline nears -- regardless of whether we're in a bull or bear market, says certified financial planner (CFP) Elaine Bedel, president of Indianapolis-based Bedel Financial Consulting. And with 33% losses, it sounds as if you're still fully invested in equities, considering that since the end of 1998, the Standard & Poor's 500 is down 31.4%.

Probably the best course of action is to develop a sell discipline -- meaning you'll sell a small percentage of your portfolio every quarter until you've reached your desired asset allocation. By dollar-cost averaging out of your equity funds, you'll hopefully avoid selling too much at what could be the bottom of the market. That said, you could also sell some shares on those days when the market has had substantial gains (keeping in mind that mutual-fund trades are executed at the end of the day), says Bedel. And remember, as painful as it is to sell at a loss, it does entitle you to some nice tax breaks.

As you pull out, you'll have to decide what to do with your cash. Unfortunately, in the current environment, your options aren't terrific. For those with a three-year investment horizon, the experts we spoke with suggested a short-term bond fund. "At some point interest rates will start going back up, and you'll have less risk on a short bond fund than you would on an intermediate or long-term bond fund," says Andrew Clark of New York-based investment tracking firm Lipper. Year-to-date, the average short-term bond fund has a 3.0% total return, compared with a loss of 26.0% for the S&P 500.

When looking for a bond fund, be sure to keep an eye on expenses, and look for a portfolio with high-quality debt, says CFP Harold Evensky of Coral Gables, Fla.-based Evensky Brown & Katz. The Vanguard Group offers few strong performers with investment minimums below $5,000. If you're in a high tax bracket (30% or higher), you might consider a tax-free municipal bond fund. Alternatively, if you have a sizeable portfolio, you could build a laddered-bond position, which could help protect you from interest-rate risk. (For more on bonds vs. bond funds, see our story.)

If you want to take absolutely no risk with at least part of your portfolio, then your best bet is a money-market fund or a certificate of deposit. Generally, we prefer money-market funds since they give you the flexibility to move your investments whenever you please. Unfortunately, even the well-performing money-market funds, like the TIAA-CREF Money Market fund (sorry, no snapshot) and the SSgA Money Market fund (sorry, no snapshot), have annual compound yields no greater than 1.65% these days. (These returns would rise were the Federal Reserve to raise interest rates, while bond funds would suffer.) Once again, if you're in a high tax bracket, you should consider a tax-free money-market fund. For a list of the best-performing money-market funds, visit iMoneyNet.com.