When volatility sends stock prices tumbling, as has been the case in recent months, what can investors do to maintain their long-term plans? First, take a deep breath and don't make any sudden moves in your portfolio. "There is no reason to scrap everything we know about investing and just sell assets," observes Russell Wild, a financial planner in Allentown, Pa., and author of Bond Investing for Dummies and Index Investing for Dummies.

"When investors are confronted with a market that's truly an anomaly, like the market we've been facing since October 2007," Wild continues, "there is a tendency to forget what decades of experience have taught us: that over long periods of time, investors may benefit from diversifying their investments among different asset classes."

A Foundation for Investment Strategies

According to Wild, diversification—and its partner, asset allocation—are the building blocks for investors' long-term plans.

A diversified portfolio is designed to manage short-term volatility. Different types of stocks and bonds often don't move in the same direction or in the same magnitude, which means that if one investment doesn't perform well, another investment could pick up the slack. To put it simply, diversification means not steering all of your savings into the same type of investment vehicle.

If diversification is an investor's goal, asset allocation is the means to achieving that goal. Investments are spread among stocks, bonds and cash instruments, as well as among different asset types in each class. Consequently, a truly diversified portfolio will hold investments in large-, mid- and small-capitalization stocks; international and domestic equities; treasury, corporate and municipal bonds; and money market funds and certificates of deposit.

"In a bear market, diversification is not always effective," Wild admits. "But longer term, diversification has been successful at smoothing out volatility. That's why I tell clients that investing in stocks and corporate bonds still makes sense. Putting all your money in cash and treasuries, on the other hand, may not be a good long-term strategy, depending on the stage of life you are in. You may eliminate a lot of short-term risk, but you may also sharply limit your portfolio's growth potential."

In the face of market volatility, and the certainty that price fluctuations will always be part of the investment process, how can you use diversification and asset allocation to your advantage? Consider the following recommendations.

Craft a Personalized Strategy

Media pundits are full of investment advice, and friends and relatives often share a tip or two. But what might work for others isn't necessarily right for you, which is why you need a plan that is driven by asset allocation and addresses your individual needs, says Wild.

"Everyone has a risk/return 'sweet spot,'" Wild explains, "which is based on such factors as a person's age, goals, health and financial condition. That unique sweet spot determines an investor's asset allocation formula—where he or she invests and how much is invested in each area of the market."

Todd Houge, Ph.D., CFA, an assistant professor of finance at the University of Iowa-Tippie College of Business, believes most investors actually need more than one asset allocation plan.

"Take the time to understand the focus and time horizon of each of your investment goals," Houge recommends. "For example, investing for college is an intermediate-term goal for most people, while investing for retirement is a long-term goal. Meanwhile, if you're already retired, living off your savings is a short-term goal.

"In other words," he continues, "how you invest, and how you allocate assets, is a function of your specific circumstances."

Don't Chase Performance

In any market environment, but especially a volatile one, investors can be "guilty of recency," says Wild, "which is the belief that what has happened in the recent past will continue into the future."

Recency can lead to chasing performance—buying the latest "hot" stock or fund and selling everything else—a dangerous choice for investors. "Chasing the herd can get you trampled," says Houge. "Individual investors can overreact to what's happening in the market, which often results in the investor making a wrong decision at the wrong time.

He continues: "If you're tempted to make an impulsive move, go back to your asset allocation plan and ask yourself, 'Why am I making this trade?' If you don't have a good answer—if nothing in your financial or personal circumstances has changed dramatically—then stick with your plan."

Periodically Rebalance Your Portfolio

Over time, market performance can cause your holdings to drift away from your current allocation—especially when volatility is high. Instead of holding 70 percent stocks and 30 percent bonds, for example, perhaps your portfolio has shifted to a 55-45 ratio. By "rebalancing" your portfolio periodically, you can keep your investments aligned with your objectives and risk tolerance.

How often should you rebalance? Houge recommends revisiting your asset allocation plan at least once a year, or whenever there has been a substantial shift in the market or a significant change in your personal circumstances.

Practice True Diversification

For individual investors, diversification and asset allocation can help manage volatility while generating growth over long periods of time. But to make these tools actually produce results, investors must do more than simply invest in one or two funds, Wild stresses.

"The degree of diversification you can take advantage of depends on the size of your portfolio," says Wild. "As your assets increase over time, so will the number of asset classes you can handle."

Houge agrees. "Diversification and asset allocation offer very positive benefits to individual investors, but only if properly employed. At a minimum, investors should spread their assets among different types of stocks, bonds and cash instruments. People often overlook cash, but it's an important component of most asset allocation plans."

Looking ahead, Houge feels that investors should continue to maintain broad diversification in their portfolios. "There is no reason to panic during a bear market and abandon your asset-allocation plan," he says. "The stock market is a forward-looking indicator and I believe it will move up in advance of the eventual rebound in the economy."