Written By: Ashok Rajan, Director of GWM Investment Management & Guidance Merrill Lynch

During the current financial crisis, many investors have taken drastic action, abandoning the markets and cashing out. Others have taken what might be called drastic inaction: They have become paralyzed, doing nothing as their losses mount.

Both reactions are completely comprehensible—after all, even the most diversified, thoughtfully designed portfolios have suffered market losses. But in markets like the present one, it’s critical to take a step back so that you can understand how you respond to risk—and to see to it that your portfolio is set up to help you handle the amount of risk that suits you.

In many respects, investing is an emotional act. It’s a way to reach financial goals, which tend to center around emotional rewards. You want the financial independence to enjoy retirement with your spouse, or to fund your children’s educations, or to establish a philanthropic legacy for the people and causes you cherish.

What’s more, the human brain is built to respond more readily to emotions than to data, according to Colin Camerer, professor of behavioral finance and economics at the California Institute of Technology. Although it may seem that people are more calculating when they make big financial decisions, the exact opposite is often true. Often investors try to time the market, getting out before losses mount and jumping back in when stocks appear to be on the rise. They become confident they see predictable patterns that can guide their decisions.

Yet this approach rarely works. If you sit on the sidelines anticipating a recovery you tend to come in either too early or too late, subjecting yourself to further losses or missing the strongest leg of a market surge. A better idea would be to lower the risk profile of your holdings, perhaps increasing the income component to provide steadier returns so you can stay in the market through good times and bad.

Recalibrate Your Risk Tolerance

With markets more turbulent than they have been in years, now is a good time to reassess your capacity for risk. Consider the pressure and urgency of your financial goals. Are tuition bills looming? Is retirement just over the horizon? Your age matters too, and it’s important to factor in such assets as your business or a second home. And, of course, think about the markets themselves, which may also require adjustments in your approach to risk. If you don’t periodically revisit your view of risk, you could be stuck with an approach that doesn’t fit the times or your circumstances.

In weighing all of these factors, it’s important to be realistic about your expectations for returns on various kinds of investments. Most traditional asset classes, such as stocks, bonds and cash, are generally expected to produce on average single-digit annual gains, with an overall portfolio delivering 5% to 8% per year before taxes. Those who need higher returns to reach their objectives have to take their chances with a higherrisk portfolio or modify their plans.

Particularly in today’s markets, reassessing risk will likely lead to less aggressive llocations. One “de-risking” scenario may involve selling a portion of more volatile equity holdings and replacing them with higherquality assets. You could, for example, redeploy some of your investment capital into U.S. Treasury bonds and a broad selection of top-rated national, as opposed to single-state, tax-advantaged municipal bonds. For stock investments, the emphasis should be on companies with strong balance sheets, growing dividends and earnings predictability.

Maximizing diversification could mean including such investments as commodities, currencies, alternative investments and real estate in your portfolio. Though not suitable for all investors, such holdings may have a stabilizing effect over the long haul, because their movements don’t tend to mirror the fluctuations of traditional stocks and bonds. However, in times of severe financial stress (as in 2008), they all moved in the same direction—down.

Having an up-to-date assessment of the markets as they relate to your goals and risk tolerance puts you in a better position to realign your portfolio to match your personal goals. It also allows you to manage a flexible strategy that can weather market downturns and position you for better times ahead.