How to Repair Your Damaged Portfolio

Repositioning your holdings after years of boom and bust.

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In the financial turmoil of the past decade, mutual fund investing became decidedly more complicated. After all, over the course of just 10 years, investors looked on as two bear markets ravaged the economy, as a pair of bull markets jolted stocks back to life, and as the Internet and housing bubbles inflated to their breaking points and then burst. The Dow Jones industrial average, the most-watched indicator of the stock market's health, closed out the decade lower than where it started, and after surging to upwards of 14,000 in 2007, it plummeted to under 7,000 early last year before the rebound kicked in. The tech-heavy Nasdaq, which at the turn of the millennium eclipsed 5,000 on the back of the dot-com binge, has since lost roughly half of its value.

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

Looking back at the rubble strewn across the market, some commentators have labeled this period the "lost decade." But it's what lies ahead that has them even more concerned. In the aftermath of a crushing recession that tested the faith of most long-term investors, Americans are now facing the daunting task of rebuilding their retirement savings.

As they do so, they will have plenty to worry about. With the unemployment rate hovering around 10 percent and a sustained period of slow growth on the horizon, annualized stock returns for the next couple of years will probably be in the single digits, says Jeffrey Kleintop, the chief market strategist at LPL Financial. More pressing concerns, such as whether Europe will be able to contain its debt crisis, have also been taking their toll. Meanwhile, as the market's recent plunge illustrates, investors can no longer count on momentum alone to anchor their portfolios. "Things truly fell apart in 2008, and in 2009 we recovered a lot of that," says Jeff Tjornehoj, Lipper's research manager for the United States and Canada. "I think the first quarter of 2010 was leftover momentum from 2009, and now we have to get back to the basics."

[See 10 Ways the European Debt Crisis Affects Your Investments.]

Where we are right now. As the market began to rally last year, something curious happened: Investors kept pulling money out of stock mutual funds. And even as these funds exploded in value, many mutual fund investors largely missed out. "Unfortunately, a lot of investors sold in early '09 and missed a tremendous rebound," says Russel Kinnel, Morningstar's director of mutual fund research.

In fact, over the 52-week period immediately after the stock market bottomed out on March 9, 2009, the S&P 500 gained roughly 70 percent. But during that same time period, investors actually yanked more money out of domestic stock funds—$8 billion more—than they put in. In the midst of that yearlong exodus from stocks, bond funds brought in a total of $409 billion as investors flocked to the least-volatile corners of the economy.

Because of these uneven flows, many investors now own portfolios that are far out of synch with their long-term goals. This will obviously have to be a temporary phenomenon if they hope to rebuild their nest eggs. But as long-term investors regain their nerve, many will be faced with the question of how best to re-enter the stock market.

The first step is to come to terms with the fact that the bulk of the rally has passed. Now that stocks are experiencing a bumpy ride, experts say that the most prudent strategy is for investors to ease back into the market. By spreading out their stock-fund buys—perhaps over the course of a full year if they pulled completely out of stocks—investors can avoid the possibility of going all in right before the market peaks and turns. "If you do it all at once and you're right, then you look brilliant. But of course if you're wrong, then you've taken another conk on the head," says Tjornehoj.

Taking the gradual approach, of course, requires a commitment to long-term planning. When the market is healthy, investors can sometimes get away with not differentiating between their short- and long-term goals. But when the economy inevitably takes a turn for the worse, they often find that they don't have enough cash to meet immediate needs. Part of what made the recession so devastating was that in the banner years before the bust, investors were gambling heavily on stocks—as opposed to stashing enough away in bond and money market funds—even when they needed instant liquidity for things like college tuition or mortgage payments.