Keeping Your Cool

By Daniel Kadlec

Margin calls. Panic. Busted nest eggs. Is this what Alan Greenspan had in mind when he began raising interest rates last June? Well, yes. To a degree anyway. And given discouraging news on inflation last Friday--the CPI has been rising at a 5.8% annual clip this year, the government reported--don't look for Greenspan to stop boosting rates soon. The ominous prospect of more rate increases, along with basic valuation questions, sent both the NASDAQ and the Dow average on another wild ride.

Yet even with stocks swinging like Tarzan on amphetamines, you're not doomed to smack into a tree. The trick: turn off CNBC, stay diversified and don't stray from autopilot investing programs like 401(k)s, IRAs, college funds and dividend-reinvestment plans.

Why should you turn off the TV? Studies have shown that unusual volatility is as likely to precede a sharp run-up as a sharp decline. If you're invested for the long haul, why put yourself through the agony of watching short-term declines--especially ones as steep as last Friday's--that tempt you to panic? I don't mean to pick on CNBC. But it's the market leader in televised stock talk, and when the market is sinking, the anchors' grim faces and funereal tones only quicken your despair. Once weaned from hourly updates, you'll find it easier to hold fast to proven long-term strategies like broad diversification and dollar-cost averaging.

Diversifying ensures that you won't suffer too much if one sector of the market tanks and that you won't get left behind if one sector takes off. It's a confidence builder that, like turning off the tube, makes you less likely to sell when stocks dip--O.K., plunge--giving others the benefit of temporary low prices. Consider: many days this year, the Dow has been up when the NASDAQ was down, and vice versa. In the past 30 days, a tech-only portfolio might easily have lost 30% to 50% of its value. Yet if that portfolio had included bank stocks, plus some basic industry and consumer-goods companies, it would have been a relatively stable collection of stocks overall.

The right mix depends on your risk tolerance. But in addition to any bonds and cash you may hold, consider spreading your money among small-cap, large-cap and international stocks in at least five unrelated industries. Diversification is most easily accomplished through mutual funds, but stock pickers can get broad exposure with just six to ten stocks. Don't run scared from tech even now. Consider a market weighting of about 30% tech stocks.

Diversifying will help you keep your sanity, but dollar-cost averaging has more quantifiable rewards. By investing a set amount at set times, you automatically buy more shares when prices are low. Gyrating prices actually improve returns over time.

Consider two stocks that start at $20. You buy $100 of each monthly for six months. One goes to $25, $10, $30, $15 and ends at $25; the other goes up $1 a month and also ends at $25. In the first example, your average cost is just $18.18 per share, giving you a 37.5% gain. In the second example, your average cost is $22.37 per share, giving you an 11.8% gain.Viewed this way, volatility is a grossly overrated problem. Sure, it's tough to watch your stocks fall. But it certainly helps if you know that the companies are solid and that you're systematically buying on the cheap.

See time.com/personal for more on volatile markets. E-mail Dan at [email protected] See him Tuesdays on cnnfn at 12:45 p.m. E.T.