Credit where credit is due: The inspiration for this article comes from a recent post on the Bogleheads forum: “A Time to Evaluate Your Jitters.” I strongly encourage you to read the post, as the author made his points more eloquently than I’ll be able to.
In the last week we’ve mentioned two productive things to do during a market downturn:
- Rebalance your portfolio, and
- Check for tax-loss harvesting opportunities.
Today let’s add a third: Get a first-hand evaluation of your risk tolerance.
Is Investing Supposed to Be This Difficult?
If my email inbox is any indication, many investors have found it difficult to stick to their investment plans this week. Their plans call for rebalancing (which in this case means selling bonds and buying more stocks), but they’re nervous about doing so.
Rebalancing isn’t supposed to be easy. Selling your better-performing assets to buy more of your worse-performing ones is difficult for most investors.
But it’s not supposed to give you an ulcer or heart attack either. If you’re experiencing that degree of hesitance to stick to your original plan, what you’re getting here is first-hand, concrete evidence that your risk tolerance is not as high as you thought it was.
If the only way you’re going to be able to sleep at night is to use a lower stock allocation than your original plan called for, then so be it. It’s a costly lesson, but it’s a valuable one too.
So don’t waste it.
Whatever stock/bond allocation you end up settling on, do not move to a more aggressive allocation in the future. Otherwise you’re likely to repeat the same mistake when the market takes its next downturn.
A lower-risk, lower-expected return allocation that you can stick with is much better than a higher-risk, higher-expected return allocation that has you panic-selling in every bear market.
But This is Unprecedented!
Several readers have told me that this week has been an exception. They’re normally risk-tolerant, but this decline has been particularly difficult to deal with because the events causing it are so unprecedented.
But that’s the point. It’s always unprecedented.
Think back to the end of 2008. The housing market was crashing. The biggest, most famous financial institutions were failing one by one, and experts were predicting that our entire financial system would literally collapse if the Federal government didn’t step in to hold the pieces together. It was unprecedented.
Or think back to 2001. The technology sector upon which we’d pinned our hopes of wealth and prosperity had started to come to pieces. Then, after about a year of the market declining, terrorists attacked us on our own soil, killing thousands of people. To say that that was unprecedented is an understatement.
Risk tolerance isn’t just about your ability to deal with abstract market declines. It’s about your ability to stay calm while your portfolio is tanking and you’re being inundated with news of frightening, sometimes genuinely catastrophic, I-never-thought-this-could-happen type events.