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5 ways to limit risk from stocks

Do you feel trapped in the stock market? It's a natural feeling, given today's conditions. The stock market is soaring to nosebleed heights, but as rational as it may seem to scale back, the lack of attractive alternatives has investors tightening their grips and preparing to hold on for the ride.

However, if you don't want to passively stay on board until the next crash, there are some things you can do short of a complete pullback from the market.

Too far, too fast?

A soaring stock market is a nice problem to have, but it is a problem.

Forget the news stories about how the market keeps reaching all-time highs. The absolute price level of the stock market -- or any individual stock -- does not matter as much as valuations. The good news is that earnings are rising. The bad news is that prices are running well ahead of earnings.

This year is on track to represent the second year in a row in which stock prices have risen faster than earnings. As a result, the price-to-earnings ratio of the S&P 500 has risen by more than 30 percent. Perhaps more alarmingly, the price-to-earnings ratio for operating earnings -- the meat and potatoes of a company's business -- has risen by more than 34 percent.

Barring an extraordinary boom in earnings, which does not seem consistent with a sluggish global economy, there are two choices for bringing prices back into alignment with earnings. Either prices can fall, or prices can wait for earnings to catch up. This leaves investors with a choice between a falling market and dead money, so alternatives, as unattractive as they may be, must be considered.

Five possibilities

If you feel trapped in the market despite concern about risk, here are five steps to consider:
  1. Reallocate new contributions. If you can't bring yourself to sell stocks, at least direct new retirement plan contributions to more conservative investments, to gradually water down your exposure.
  2. Shift to more defensive stocks. You can keep your stock position where it is, but perhaps slide some money from high fliers into more plodding-but-sturdy sectors of the market.
  3. Take a microscope to your portfolio. Never mind big-picture generalizations about the market and valuations -- how do the individual stocks in your portfolio look when you examine them close up? Now would be a good time to consider whether you have diminished expectations for any of their business models going forward, or if some valuations have made too great a leap from reality.
  4. Decide when to sell, if not now. With respect to either individual stocks or the level of the market as a whole, if you can't bear to sell now, then set targets for when you would be willing to sell. Setting those targets in advance will make it easier to follow through when the time comes.
  5. Remember that a small positive beats a negative. Saving account rates of less than 1 percent and certificate of deposit rates in the 1 to 2 percent range may not seem like great alternatives, but those positive numbers would look pretty good compared to a 10 or 20 percent decline in stocks.

Market psychology is a powerful thing, but it is just psychology. You are not really as trapped in the market as you might feel.

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