5 Moves to Make Before the Stock Market Rally Ends

Workers hang a giant American Flag on the exterior of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, May 25, 2012. U.S. stocks rose, giving the Standard & Poor’s 500 Index its first weekly rally since April, as investors were lured by the cheapest valuations since November. Photographer: Scott Eells/Bloomberg
(Scott Eells, Bloomberg)

With the Dow Jones industrial average (^DJI) soaring to new all-time highs, investors are enjoying the new-found prosperity reflected in their brokerage statements. But it you want to keep those paper profits, now's the time to start making some tough decisions. Otherwise, those gains could go up in smoke when the rally ends.

That moment may not come anytime soon, but if history is any guide, it's wise to prepare.

The last time the Dow was at all-time highs was in 2007. After the early 2000 tech-stock bubble implosion (which sent the Nasdaq Composite (^IXIC) down more than 70 percent), the market rallied and, after a five-year run, appeared to have finally shaken off the shock.

Less than 18 months later, the Dow lost more than half its value -- a plunge that it took stocks four years to recover from.

Millions of investors suffered huge losses that forced them to change their plans for retirement and postpone other life goals. Whether or not you were among them, you can still learn from their mistakes. Here are five things to do before the current rally ends.

1. Spread your wealth around, and then mix it up even more.

Having all your eggs in one investment basket greatly increases the risk of a major loss when a market rally ends. In order to prevent one particular investment from sabotaging your life savings, financial advisors recommend owning a variety of different investments in your portfolio. That way, you can survive even if one of your holdings plummets in value.

To get the full benefits of diversification, you should have portions of your money in stocks, bonds, cash, real estate, and other broad-based asset classes.

But even within those asset classes, you should further diversify among different individual holdings. Doing so will go a long way toward truly protecting yourself from massive financial harm when the market's advance comes to a halt.

2. Part ways with some of your winners.

Even if your investments are already diversified, the stock market's advance may have left you with more money in equities than you're comfortable with. Back in 2007, many investors were surprised to find just how much risk they'd inadvertently taken on in their portfolios.

Rebalancing involves selling off some of your winning investments and putting the proceeds into investments that have lagged behind. By rebalancing, you sell high and buy low, which is always a good habit to get into as an investor.

3. Free up some spending cash for the market's markdown madness.

When markets move straight up, being fully invested makes you the most money. But not having any additional cash to invest becomes problematic when a rally ends and new stock bargains start popping up.

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With stocks at record highs, now's a great time to sell off portions of your holdings to raise cash for future investment. Low interest rates on savings won't reward you for keeping cash, but the eventual stock bargains you'll find will make the waiting worth it.

4. Face the naked truth before anyone gets undressed.

When the market's at record highs, just about every stock looks good. But when a long market advance ends, the first hint of a drop can expose risks that most investors aren't thinking about during the good times.

What looks like a simple pause in growth can turn into plunging sales if the economy heads south, and an inability to raise dividends during good times can lead to a company making a massive dividend cut at the first sign of trouble.

Referring to this phenomenon, superinvestor Warren Buffett once said, "You never know who's swimming naked until the tide goes out." Don't let rosy conditions blind you to what can happen to your stocks when the bull market ends, and if your stocks have unacceptable risk, take the opportunity to replace them while they still fetch a premium price.

5. Fight your natural avoidance urges.

The hardest thing when a downturn hits is to stick with your investing strategy. But over time, investors have made just as much if not more money by buying stocks during downturns as they make investing in bull markets.

The key, though, is understanding that when the outlook for stocks sours, your emotions will be telling you not to invest in them. Keeping a long-term view is vital if you're going to take advantage of cheaper investments. Prices drops that lead to undervalued stocks usually don't last long, so planning out in advance what you'll do and when you'll do it can make the difference between missing an opportunity and profiting from it.

Yes, the Rally Will End

It may not be today, tomorrow, next week, or even next year, but at some point, the bull market will end. Whenever it happens, the next downturn will separate those who prepared from those who didn't. Make sure you're one of the smart ones who'll not only survive the next downturn but thrive from it.