The Only Defense for Your Portfolio

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Well, it's happened again.

You swore you'd be ready the next time the bottom fell out of the market. You'd have your defense planned, your next investments prepared, your watchlist well-stocked, and your bargains lined up.

So here's your chance. Are you ready?

Another big swoon
Yes, yesterday's 500-point drop in the Dow brought back memories of those days in late 2008 when what would later grow into the market meltdown was just beginning. Back then, it seemed like there was nowhere to hide; if you had just about any investment, it was down for the count.

This time around, things are much the same. Just take a look at the general carnage from yesterday:

What's more, among the hardest-hit stocks, you don't see any obvious trend. There were plenty of earnings-related problems, ranging from energy stocks Walter Energy (NYS: WLT) and Western Refining (NYS: WNR) to Dendreon's (NAS: DNDN) big disappointment over its Provenge drug to Aeropostale (NYS: ARO) and its nearly 25% plunge. Basically, companies from every sector took a hit.

The worst investment that went up
Amid the devastation, the only investments that did extraordinarily well were bonds. Treasuries in particular saw immense gains, with short-term yields going pretty much to zero and long-term bonds rising 2.5% and more in price. That may not seem like much if you're familiar with the volatility of stocks, but a nearly three-point move for T-bonds is an amazing day.

Given that price action, you might think that Treasuries are the only defense for your portfolio. But before you jump in, think about what you commit to with a Treasury right now. Buy a 10-year Treasury today, and you'll pay about $1,060. In exchange, you'll get interest payments of not quite $16 every six months from now until 2021, and then you won't even get your $1,060 back, as the bond's par value is only $1,000.

In other words, you'll get $320 in total interest over 10 years, offset by a $60 capital loss at the end. You'll also get to pay taxes on that interest. And none of that takes into account the impact of falling purchasing power, which will make the $1,000 you get at the end worth closer to $750 even if inflation stays at 3% -- a bold assumption.

Your only real defense
What yesterday shows is that sometimes, the only way to reap long-term rewards is to suffer through short-term pain. In football, shutouts are very rare -- and in pro basketball, a winning team typically still gives up at least 80 points and often much more.

Similarly, you're not going to be able to avoid all the down days in the market. But by doing three things, you can make sure you'll get its long-term benefits:

Market downdrafts have happened before, and they'll happen again. Get comfortable with them, and you may even come to see them as a healthy part of a profitable investing strategy.

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At the time this article was published Fool contributorDan Caplingerknows a great offense is the best defense. You can follow him on Twitter here. He owns shares of the Vanguard MSCI Emerging Markets and iShares MSCI EAFE ETFs. The Motley Fool owns shares of Coca-Cola, Vanguard MSCI Emerging Markets ETF, Aeropostale, and Western Refining. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Pfizer, and Walter Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policywon't panic on you.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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