Investors deal with nasty stock market mood swings

Mood swings aren't just something you see in middle schools. The stock market is rife with them these days, and investors had better get used to it.

Ever since the Federal Reserve announced its highly anticipated interest rate hike last week, stocks have been on a triple-digit joy ride. Moves by the Dow Jones industrial average have ranged from up 224 points — or 1.5% — on the day of the announcement on Dec. 16 to down 367 — or 2.1% — just two days later.

Such big moves are really just following the playbook. Volatility typically picks up after the start of a rate-tightening cycle, says Sam Stovall, U.S. equity strategist at S&P Capital IQ. In fact, volatility was already on the rise going into the Fed meeting. Nearly two out of every three days this December, the S&P 500 rose or fell 1% on a closing basis, Stovall says. That is double the fewer than 30% of all trading days in 2015 that have had a 1% rise or fall.

Swings in stock prices could get even more exciting going forward. In the past 50 years, the number of up or down days of at least 1% averaged 16.4 in the three months after an initial Fed rate hike in a tightening cycle, vs. an average of 9.3 for the three months leading up to the hike, according to Stovall.

With that in mind, here's what the experts suggest smart investors do during periods of extreme volatility:

• Be diversified. Spreading your portfolio between different types of asset classes is the best way to ride a wild stock market without getting thrown off. That means adding so-called "value" priced stocks with relatively low valuations, real-estate investment trusts, foreign stocks as well as bonds to your mix. The results are impressive. The broadly diversified IFA Index Portfolio 70, which is only 70% exposed to stocks, has generated exactly the same average annual return, 9.8%, as the Standard & Poor's 500. But this diversified portfolio has gotten the same return with 18% less risk.

• Be careful. If you're speculating on individual stocks, you are taking on more risk by default. The risk goes up dramatically, especially if you're buying small companies with high valuations. Just ask GoPro investors, who have lost 70% of their money this year. If you own these types of stocks, you need to be prepared to cut your losses. Professionals recommend cutting losses at 10% of the price you paid.

• Be prepared. Financial advisers recommend you have at least three months of living expenses out of the market — if not more. Having this cash cushion is important as you'll be less likely to panic when the market starts to churn since you know you have your rent money.

The Fed's move may not kill the bull market. But it will certainly make it more difficult to hang on.