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Commentary

5 Things to Do in a Market Meltdown

Reacting out of panic--and without a plan--is rarely a good move.

The market has been brutal over the last few days as concerns over China, Fed rate hikes, and commodity weakness have converged into a perfect storm of worry. These are trying times for investors, invoking stress that hasn't been felt so acutely since 2011 at the height of the eurozone crisis, and conjuring bad memories of 2008.

Although such times in the market make us feel like we need to do something, reacting out of panic is rarely a good strategy. Instead, take a few minutes to read through these steps and think about your own investments and your own long-term plan. Then you'll know if action really is warranted, and if so, exactly what do to.

1. Check Your Asset Allocation and Cash Reserves
If you're depending on your portfolio for day-to-day cash needs, you'll want to ensure you have adequate liquid reserves to cover your short- to medium-term expenses (bucket No. 1 in Christine Benz's retirement bucket portfolio approach). If you need to rebalance your portfolio to refill Bucket No. 1, you can do so, but be disciplined. Sell positions that have moved beyond your allocation targets and add to those that are below target (including cash, if that is underallocated), rather than blindly selling stocks because they are suffering right now. And resist the urge to overfill bucket No. 1 (which should contain one to two years' worth of living expenses).

2. Think About Your Long-Term Plan
If you're not in retirement and don't need liquid reserves, the best reaction may be to do nothing unless your asset allocation targets are way out of whack. Remember, if you dramatically change the asset allocation of your portfolio, you are dramatically changing your long-term investment plan. Before you do such a thing, think about your strategy for this new portfolio, and ask yourself if it will get you where you need to go in 10, 20, or 30 years.

Remember, most people, even those in retirement, need the long-term earning potential of stocks to ensure they meet their financial objectives. Yes, it's sometimes painful to hold stocks in the short run, but that's the price you pay for the long-run higher returns a well-diversified stock portfolio can offer. If you've determined you need stocks for your long-term plan, a short-term market correction shouldn't change that need.

And if you think you can sell stocks now and buy them back later at the bottom, think again. How many times after 2008 did it look like the market was ready to roll over again? No magic bell will ring when stocks are ready to start climbing once again. In the meantime, investors who are stuck sitting on the sidelines can end up missing the bulk of a recovery--and hence, a major component of stocks' longer-term returns.

3. Never Forget Valuations
After Monday's sell-off, the stock market as a whole will likely be more than 10% undervalued. That's based on the median fair value estimate of stocks under Morningstar coverage compared with current market valuation levels. If the sell-off continues to intensify, that discount will only increase.

Think about any tangible asset that you hold: a house or a piece of fine art. You wouldn't sell it if the buyer wasn't offering you a fair price. It should be the same with your equity holdings. If you don't need the cash today, why would you sell when they are distressed? If you must sell for a critical need, then you must sell. But if you don't need to sell, don't turn paper losses into real ones.

It also can help to keep longer-term performance in mind. Yes, the last few days have been painful, but remember that the S&P 500 has returned about 15% per year for the last five years. After the value of any asset appreciates well above the normal range of historical returns for a sustained amount of time, a period of adjustment shouldn't come as a huge surprise.

4. Get Ready for Bargain-Hunting
On Monday morning, Morningstar's market fair value stood at 0.92. That means the median stock in Morningstar's coverage universe was 8% undervalued before the market opened Monday. If the sell-off continues today, the market will look even more undervalued. That means some individual stocks--including some wide-moat names--may start to look attractive. As stocks have risen in recent times, the number of great (wide-moat) companies selling at a discount has been vanishingly small. These market corrections can provide value hunters an opportunity they've been waiting for.

But before you jump in with both feet, do keep some perspective. Our market fair value got down to 0.8 in 2011 and 0.55 in 2008-2009. We're not saying today's market is headed there--no one can really know for sure. Rather, we're simply pointing out that markets that have fallen can fall further--sometimes much further. The best value investors are often early, and sometimes see their picks drop in value quite a bit before recovering.

Bargain-hunters have to be prepared for that possibility and should seek out the strongest firms that can weather tough times and even benefit from weakness among their competitors. Morningstar's  wide-moat-rated stocks with low uncertainty are a good place to start looking. When these names dip into 4- or 5-star territory (meaning they are trading at a good discount to fair value), take an even closer look.

5. Still Feeling Stressed? Let Off Some Steam
When the bottom falls out of the market, sometimes you just need a release valve. If it will help you to sell a small amount (I'm talking 5% or so) of your stock stake and move the money to cash, if it will keep you from selling all of your stock stake and blowing up your long-term plan, then release some steam. But afterward, turn off CNBC, walk away, and take a deep breath. Think about your long-term plan and what kind of assets you need to get there. Think about how the market has been through this before, many times and much worse. Remember that these bouts of stress are why stocks return more than other assets to begin with. If stocks were steady-eddy, up-and-to-the-right all the time, they would not have the return potential they do. And your long-term portfolio would suffer because of it.