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How to Protect Yourself From the Selloff

Most portfolios have taken hits over the past five weeks.

The S&P 500 Index was down 3.1% in May and was down an additional 0.5% thus far in June.

And many individual stocks and actively managed equity funds have sustained even bigger declines because of the recent selloffs.

Can you expect additional corrections this year? More importantly, how can you defend yourself from this kind of volatility?

If you have not already done so, be sure to include "dividend indices" and "value indices" in your portfolio.

In fact, this may be a good time to buy these specialized indices. They make excellent additions to your portfolio in volatile times.

A "dividend index" is an index of the 50 to 100 highest dividend-yielding stocks.

A "value index" is essentially a basket of equities having lower-than-average prices as determined by their price-to-book and price-to-earnings ratios.

"Value" stocks are deemed to be reasonably priced vis-a-vis real earnings.

By comparison, "growth" stocks trade at higher multiples to earnings.

Although value stocks and value indices focus on attractive pricing relative to actual earnings being achieved now, growth stocks and growth indices focus on "future potential."

Here is a picture of how several different index funds and exchange-traded funds have fared thus far in 2006.

Ports in a Storm
Value and dividend indexes hold up better in down markets.
Symbol Fund or ETF Performance
1 Month YTD 12 Months 3 Years Annualized
vfinx Vanguard 500 Index -4.48% 2.02% 7.38% 10.37%
fsmkx Fidelity Spartan 500 Index -4.47% 2.06% 7.47% 10.41%
vtsmx Vanguard Total Stock Market Index -5.08% 2.45% 9.03% 12.06%
dvy iShares Dow Jones Dividend Index -2.34% 3.94% 5.65% NA
vivax Vanguard Value Index Fund -3.39% 5.24% 11.69% 14.15%

All of these index funds sustained losses over the last thirty days -- corrections in the range of 2% to 5%. But the indices focused on dividend payers and/or value stocks had lower corrections. In fact, the iShares Dow Jones Dividend Index (DVY) actually had positive trailing one-month results as of Friday's close. Both the dividend and value indices -- DVY and (VIVAX) Vanguard Value Index fund -- have also produced higher year-to-date returns and higher annualized three-year returns than conventional index funds.

Clearly, investing for value and dividends is not failsafe: Each of these indices incurred significant losses -- at least 20% -- in 2002 when the stock market underwent a massive correction. But this investing style has long-term performance advantages.

According to Standard & Poor's, the shares of companies that do not pay dividends in the S&P 500 were down 4.67% during the month of May. The stocks of companies that do pay dividends, however, were down 2.37% during the same period. That's a substantial difference. Lesson one: It's better to hold dividend-payers and intrinsic value.

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