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Stock market investing in times of crises

Investors are tested time and again by market uncertainties and catastrophes. How you react to market events can make or break your portfolio returns over the long term. Test your stock market investing acumen in these extreme scenarios. Choose the option that's close to what you might actually do to see how the choice plays out. Note: Technically, the correct answer to any question about investing is, "It depends." As you play this game, realize that the ambiguities and nuances of real life may result in different outcomes.

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You're a 45-year-old aiming to retire at age 70.

Here's your portfolio: It's a single 401(k) account worth $250,000, split between 70% stocks and 30% bonds, all index mutual funds.

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Global financial disaster sends markets into a tailspin

What would you do if a calamitous world event caused the stock market to plunge 10% in a single day and kept going, ending the week down 20%? At this point, your portfolio is in tatters: You've lost $35,000. Meanwhile, calamitous world events drag on, and who knows what markets will do? What do you do?

Sell all your stock mutual funds and plan to tactically redeploy funds once the dust settles.

Do nothing different. Everything will work itself out in the long run.

Wait for a clear sign that a bottom is in sight and pounce on the hardest hit sectors.

Probably a bad move.

First the scolding: You should have been better prepared for a serious downturn, according to Herbert G. Hopwood, CFP, CFA, president at Hopwood Financial Services in Great Falls, Virginia.

Don't compound the problem by acting on impulse, though. "If a major event does occur and you haven't done the planning, sleep on it. Don't make an impulsive decision," he says. The basic problem with the run-for-the-hills strategy: Losses are locked in and trading costs are incurred on top of those losses.

"Don't go all-in and you don't go all-out. If, after 24 hours, you say, 'OK, I really had the incorrect allocation,' you don't go from 80 percent in equities to zero. If you really can't stomach it, take some off the table," Hopwood says. Some people swear by market-timing strategies using moving averages or other technical indicators, but without a plan to exit ahead of time, you're just flailing in the dark.

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This could work in your favor.

Stock prices are sometimes referred to as "mean reverting." That suggests that prices may swing to extremes but generally move back toward the average. If stock prices are mean reverting, that also suggests that the risk of stocks goes down with a very long investing time horizon, according to a 2012 paper by economists at the Dutch central bank, De Nederlandsche Bank.

That means people with a long investment time frame who continue to dollar-cost average into their investments in a workplace retirement account during a downturn will most likely benefit in the long run.

In fact, investors with a long time until retirement "should almost be looking at it as a buying opportunity. If you're dollar-cost averaging in, which you have to do with a 401(k), you should almost cheer because you're buying (stocks) at a cheaper price," says Herbert G. Hopwood, CFP, CFA, president at Hopwood Financial Services in Great Falls, Virginia.

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It's risky, but could pay off if you're right.

Investing icons such as Warren Buffett and Sir John Templeton made their names by hewing to a contrarian outlook. It's the rare individual who can rationally analyze investments and stick with them when the tides turn, but developing some emotional grit is nearly a requirement of investors.

"You need to lean a little bit against the wind," says Herbert G. Hopwood, CFP, CFA, president at Hopwood Financial Services in Great Falls, Virginia.

"When it hurts the most is probably when you need to invest. My approach is: Don't do things to extremes," he says.

One way of cautiously testing the contrarian waters is through rebalancing.

"It's very easy to take some of the winners out of your portfolio; sell the ones doing better and allocate a percentage to the ones that aren't doing so well," says Robert Laura, president and co-founder of Synergos Financial Group in Brighton, Michigan.

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Inflation begins to skyrocket

What would you do if prices for consumer goods shot up and kept going month after month? This scenario begins as inflation starts to spiral upward. Two things are certain: Prices are still going up and Fed watchers believe central bank action is imminent. What do you do?

Buy stocks, sell bonds

Sell stocks and buy bonds.

Sell everything and buy real assets -- shiny gold assets.

Making the best of a bad situation could work in your favor.

The initial phases of a serious inflationary environment can actually be good for stock prices.

"With inflation come higher yields, higher interest rates; higher interest rates make the price of fixed income -- bonds -- go down. As fixed-income prices go down and yields rise, stocks should rise with that," says Michael Gayed, CFA, chief investment strategist at Pension Partners and co-portfolio manager of the ATAC Inflation Rotation Fund.

"Companies can better adjust to rising inflation, through earnings management, for instance. Stocks at one point become a way of playing inflation, but not always," he says.

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Bad timing could cost you.

On the way up, inflation helps stock prices. The response by the central bank to rising inflation can be dangerous for bonds, however. The central bank reacts to increases in inflation by hiking interest rates. As a result, existing bonds lose value.

Tactical investors may find that the inflationary cycle serves up a couple of opportunities for active investment decisions.

"In the initial stages to the middle, the correct response would be overweight equities, underweight fixed income. Towards the latter end after a period of very high inflation and the expectation is one of Fed withdrawal, that is where you want to go back to fixed income," says Michael Gayed, CFA, chief investment strategist at Pension Partners and co-portfolio manager of the ATAC Inflation Rotation Fund.

The difficulty of executing a contrarian strategy enters here.

"In that point in the cycle, fixed income would have had so many losses no one would touch it. People are always chasing price. They've seen the fixed-income portion of their portfolio going down for years; they're probably going to keep selling. Nobody buys low, sells high; they buy high and sell higher," Gayed says.

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Probably a bad idea.

Investment returns on commodities are generally uncorrelated to the stock market, which makes them good to have in small doses as portfolio diversifiers. But betting the farm on them could be more risky than individual investors would prefer. More to the point, the inflation-hedging power of commodities may not be that great, according to recent studies.

For instance, in 2013, researchers looked at past inflationary periods and concluded that the prices of most commodities don't keep up with inflation over a long period of time. Though there have been periods where individual commodities did better than stocks, in general stocks have done better. Between 1960 and 2012, energy was the best commodity to own and, over that time frame, "stocks outperformed every commodity, including energy, with less volatility," according to the paper "Commodities as inflation protection," by Andrew Marks and George Crawford at The Investment Research Foundation and Jim Kyung-Soo Liew at Carey Business School at Johns Hopkins University.

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A credit crunch freezes the banking system of a world superpower and deflation takes hold in economies around the world, including the U.S.

The U.S. economy grinds slowly to a halt and inflation barely registers at 0.1% and falling. What would you do as deflation takes hold?

Buy investments with a lot of inherent value such as stocks and commodities.

Sell some stocks and stick with cash until you think the bottom is in sight.

Sell some stocks, buy some bonds.

It may not be the best time to invest.

If prices are on the way down, postpone any major investments.

Making a big investment before prices fall is like buying a Florida condo in 2007. Few in that situation were happy with their decision.

Luckily, deflation is not exactly the natural state of the economy. In the past 100 years, less than a handful of years have been deflationary, says Robert Fragasso, CFP, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.

In a deflationary period, investors want to reverse the way they would invest in an inflationary period, according to Fragasso.

"In a deflationary period, you want to invest in cash and you can buy more things at cheaper prices later," he says.

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Cash may be the best choice when prices are falling.

With stock market investing, timing the market is difficult to impossible, but if investors are able to pare some risky investments at the beginning of a deflationary period and begin buying back in when prices have bottomed out, they could end up ahead.

"If I expect a deflationary period, I will have ideally sold some investments before they went down in price," says Robert Fragasso, CFP, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.

"Then have the fortitude and the courage of your convictions to buy when (the market) has gone down substantially. Have nerves of steel and buy when nobody else wants it," he says.

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Owners of bonds issued prior to the deflationary period could come out on top -- provided the bond issuer stays in business.

If you buy a bond before a deflationary period, you could end up sitting pretty. Prices on existing bonds will rise as the central bank drops interest rates to fight deflation. Plus, bondholders get interest income at a higher level than prevailing rates as long as businesses are able to keep making interest payments. Because a real deflationary period would make it difficult for businesses to sell their goods and services, defaults on bonds could increase.

"Be careful of the creditworthiness of the issuer. A lesser credit might go bankrupt in the deflationary downdraft," says Robert Fragasso, CFP, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.

Borrowers -- bond issuers -- get the short end of the stick in deflation. They're repaying the principal on existing bonds at a high rate of interest with relatively pricey dollars: As prices fall, a dollar generally purchases more and more. On the other hand, bondholders who bought notes before deflation get a great deal.

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