Question: I am glad the stock market has been doing so well, but with all the political problems in Washington, I worry that we might see another collapse. How do I know if my investments are too risky and how can I protect myself?
Answer: The amount of portfolio risk that is appropriate for you depends on your personal circumstances, including your age, income level, and investment experience. In addition, a number of tools are available that can help you better understand your tolerance for risk. Among the best is Finametrica (www.myrisktolerance.com). For a small fee they will allow you to take their survey, rank order your results with the thousands of others in their database and then give you a report showing how you stack up. I’ve used Finametrica with clients for years and it was very helpful. However, there is more to the question of portfolio risk management than a risk tolerance survey alone can answer.
People often confuse the unpleasantness of gyrating market prices with the danger of actually losing money. When they do this, emotions take over and they tend to make poor investment decisions. Often it isn’t the market’s turbulence that puts an investor’s financial well-being at risk; rather, it is the investor’s reaction to the market’s turbulence. If you learn to manage your emotional response to market declines, you go a long way toward eliminating one of the major risks of investing.
A good first step is to develop a clear understanding of why you are investing. The best way to achieve this clarity is through a well-developed financial plan. A financial plan will help you see when you will need to draw upon your investments and will help you gauge the kinds of risks that are appropriate for you.
Another good way to reduce your emotional response to the market is to build your portfolio so that it can accommodate typical market behavior. For example, according to a study published by JP Morgan, the S&P 500 stock market index has experienced 10 major downturns since the Great Depression. (The study defined a major downturn as a drop of 20 percent or more.) During those downturns, the market took an average 4.6 years to return to its pre-collapse level. Therefore, if you know you will need to withdraw funds from your portfolio within the next five years, don’t invest that money in the stock market. Invest it instead in short-term bonds or CDs. Knowing you have a buffer to cover your near-term needs will allow you to have patience as the market recovers from the downturn.
Your portfolio structure should also reflect your anticipated holding period. Numerous studies have shown that the probability of losing money in the stock market falls from 30 percent for any one-year period to less than 1 percent for a ten-year period. Therefore, the longer your overall investment horizon, the more of your portfolio you should invest in stocks. A larger long-term allocation to stocks will also provide better protection against inflation, always a serious threat to long-term savings.
Bad markets are a simple fact of life. However, if you take the necessary steps to minimize your emotional response to market turbulence, you can significantly reduce the damage you will experience in market downturns.
Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.