TURMOIL IN THE MARKETS : Q&A; : What It Means for Investors

What does the tumult in the stock and bond markets mean for individual investors? What should you do with your money? Here are some answers to these and other questions:

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Q What is happening to the financial markets?

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A There’s been a major selloff in both the stock and bond markets, which is mainly attributed to a rise in interest rates and inflation fears, triggered when the Federal Reserve Board on Feb. 4 opted to hike a key short-term interest rate (the federal funds rate) by a quarter of a percentage point.

Falling rates--which helped stimulate economic growth while reducing the attractiveness of alternative investments such as savings accounts and money market funds--had been a key reason for an almost continuous three-year rise in stock prices. Falling rates had also created profits for bond investors, because it made their bonds--issued at higher yields--more valuable.

But for many investors, the Fed’s action signaled an end to three years of falling interest rates. And investors have been further spooked by signs of rising inflation, which could lead to further interest rate hikes by the Fed.

Also, big investors, including so-called hedge funds, have been unloading bonds, putting further pressure on bond prices to fall and yields to rise. (Yields and prices move in opposite directions.)

Interestingly, however, the U.S. economy is on a roll, posting strong growth that is reflected in higher corporate profits, consumer spending, home and auto sales--factors that should boost stock prices.

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Q Is this the start of a long slide in stock prices a so-called bear market--or is this a buying opportunity?

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A Market experts are divided. Some say today’s market is as much as 50% overvalued; they expect the Dow Jones industrial average to drop below 3,000 before the correction is over.

Others maintain that while the market is likely to remain volatile in the near term, longer-term prospects look bright because the economy is gaining steam.

Overall, however, nearly everyone believes this market bears close scrutiny.

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Q What should I do now?

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A The answer depends, in part, on your investment horizon.

If you’ve got lots of time before you’ll need your money, you should look beyond today’s volatility and ask yourself two questions: Are U.S. companies likely to grow and prosper over the next decade, just as they have grown and prospered throughout the nation’s history? If so, are the companies or mutual funds that you invested in likely to share in the positive effects of that growth?

Unless you’ve invested in poorly managed funds or companies, the answer is probably yes. In that case, don’t panic. You can afford to ride out the current tumult.

But if you’ll need your money within five years and cannot afford to risk any loss of principal, the issues are different. Seriously consider cashing in some investments and putting the proceeds in a bank or money market fund. The markets may do well over the long haul, but in the short run they can be highly volatile. You don’t want to be in a position where you’re forced to sell at a bad time.

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Q I’d like to stay invested in mutual funds and individual stocks and bonds. Should I adjust my mix?

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A Do a portfolio review, taking a realistic look at your investments to determine whether the fundamental reasons that you invested still hold.

Some stocks are likely to do well over the coming months, even if the Dow Jones industrial average dives. That means looking at the revenue and earnings prospects of companies in which you hold stock; looking at the investment objectives of your mutual funds, and considering the yields, credit quality and maturity dates of your bonds.

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Q Are there any investments that look good right now?

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A Some experts believe the op portunities are good in mortgage-backed securities. “Ginnie Mae” mutual funds look particularly attractive because the underlying mortgages in these funds are insured by the federal government.

When rates are falling, these funds look risky because of something called “prepayment risk,” which boils down to mortgage borrowers paying off their loans early and giving you back your principal at a time when your reinvestment opportunities are limited. But when interest rates are rising, prepayment risk is slight, says Peter Van Dyke, managing director of T. Rowe Price in Baltimore.

Individual stock investments may also be sound as long as investors choose carefully, says Richard Bernstein, manager of quantitative analysis at Merrill Lynch in New York. Look for companies that will do well in an improving economy, such as manufacturers, industrial concerns and conglomerates, he says.