Taming the volatility tiger: Four tips for dealing with jumpy financial markets

NEW YORK -- You've followed the headlines closely. Or maybe you're in shock and looking the other way. Financial indigestion gives you indigestion, and you're a long-term "Millionaire Zone" investor anyway, so who cares? Yet it's hard to altogether ignore the tummy rumbles of Wall Street.

So what should you think about it all?

I know I'm one of many financial journalists. We each have our opinions, founded and grounded on a current but rapidly changing set of facts.
And we don't know everything. We keep hearing that this credit crisis, unlike others, runs much deeper than most. It's what lies below the surface -- the risk-spreading, the complex derivatives -- that make it hard for even the pros to know who's really holding the bag.

So it is a little scary. But I tend to look for the upside and the opportunity in any changing market. It's what keeps me going -- and as a value investor, it keeps me looking for opportunity where things have been overdone. So here's my take.

Get healthy by getting sick

We had this coming. Too big a rise in asset values (real estate, commodities, stock markets) fueled by too much easy credit, too many buyers who didn't have enough before suddenly did have enough solely through easy credit. It had to end sooner or later.

And just as a vaccination causes a little sickness to prevent a big one, I believe we'll end up stronger for it all.

Here's why: a return to realism. Call it financial conservatism if you want. But I call it reversion to prudence and normalcy. I see this reversion pattern in all of the following, all leading to a stronger and more stable economy:

• Lending practices. Clearly, lending practices -- especially no-money-down mortgages -- got way out of hand and should go the way of the dodo bird. Borrowers should make a commitment and be tested for ability and willingness to pay -- not only in today's but also future interest-rate scenarios. No exceptions. And those who make loans should take responsibility for them. The fact that "wholesale" money dried up to fund these excessive loans is a good thing.

•  Real estate prices and employment. Real estate and housing should be built only when there's real demand -- from buyers that need and can afford the product. Not just anyone who can snag a loan to bet on price increases. And real-estate generated employment distortions should also fade into history. In some metro areas, 30% to 40% of employment comes from some element of the real estate or construction business. That's scary: too much dependence on borrowed money. 

•  Commodity prices. Distortions in commodity prices should also moderate. The price of oil in particular is on a long-term up trend, but a cooler economy with no excess puts less demand on resources giving less inflationary pressure. Result: the stability and predictability everyone wants. 

•  Overvalued stocks. Finally, as you're now seeing, these events will purge some stock market excesses. Lenders, commodity producers and producers of products in demand because of easy credit will return to earth.

Could we get sicker?

Since we don't know what we don't know, there's always risk it could get worse, that disruptions in credit could lead to something bigger. It didn't in 1997 and 1998, but that was then, this is now.

Charles Schwab chief investment strategist Liz Ann Sonders said it best in a recent New York Times story: "There are a lot of risks in front of us ...[but] financial crises, in the past, when not accompanied with a recession have been good for the markets."

I completely agree.

My advice

1. Be patient. You're a long-term investor, don't forget that. As Northern California financial planners J. Jeffrey Lambert and Jim Johnson put it in a recent client letter: "We view this as part of the normal operation of markets....the markets from time to time act emotionally but are rational over longer periods." So don't jump to conclusions -- nor to actions you might regret later.

2. Preserve and grow reserves. I'm pleased to see savings rates, which had gone negative earlier this year, have once again returned to positive territory. Families with savings reserves are more insulated from economic shocks -- job loss, large bills, interest rate changes, etc. The point: don't depend on credit to get through the speed bumps -- if you're in position to save, save. Six months worth of your income at least.

3. Avoid especially risky investments. Along with more prudent financial industry practices, investments and loans are now being reappraised to reflect the risk they carry. That's a good thing. But it may be a poor time to buy high-risk income investments, Chinese stocks, etc. There will come a time, perhaps -- but not yet.

4. Take advantage -- with caution. Many babies have been thrown out with the bath water. Most companies in the financial-services industry have taken a hit, and will be presumed guilty of risky practices until proven innocent. But I think it's a good opportunity to put at least a few solid financial companies -- banks in particular -- on your stock watch list. A fellow in Omaha named Buffett is reportedly doing the same. Such bellwethers as Bank of America and Wachovia and regional players Regions Bank and Fifth Third make sense, and there are many others. They have a high yield, and these institutions are strong enough to withstand some pressure.

So, in sum: watch if you want to, don't watch if you don't want to. Either way, don't panic, and stay smart.

Peter Sander contributed to this article.