Market Conditions Shouldn’t Sway Your Risk Tolerance
Last week, I talked about investors who make the drastic change from stocks to bonds or cash based on the troubled market. In this week’s edition of the “From the Front Lines” mini-series, I wanted to expand on that by talking about the people I meet with who suddenly change their risk tolerance based on the current market conditions.
When the market is down and you are losing money, it is reasonable to question your investments. Nobody likes to lose money, but it is how you react to the losses that will determine whether you retire rich versus poor. Foolish investors will constantly change their investments based on emotion, and smart investors will create a suitable portfolio that works in both good times and bad.
Understanding Asset Allocation
To mitigate risk, most people turn to asset allocation. This simply means that you create a portfolio that contains a number of different asset classes–stocks, bonds, domestic stock, foreign stock, large-cap, small-cap, and so on. Since it is virtually impossible to always know which class will perform the best for a given period of time, if you spread your money across many different classes, you’ll take the guesswork out of investing and spread your risk out.
When you create a diversified portfolio, what you’re really doing is determining how much risk you’re willing to take. If you are invested entirely in stocks, you’re saying that you have a high risk tolerance because you’re at the mercy of the market. The chances of both significant gains and losses are possible in a short amount of time. If you create a portfolio that contains an equal mix of stocks and fixed income, you’re somewhere in the middle of the road. You want to have an opportunity for making money in a bull market, but you also want to limit your losses on the downside. And finally, if your portfolio is almost entirely in fixed income or bonds, you’re saying that you can’t tolerate much risk at all and don’t want to see your account decline in value.
There is no right or wrong allocation, and many of the recommendations you hear are just that–recommendations. You can be 70 years old and perfectly comfortable investing entirely in foreign stocks, just as you can be 30 years old and stick to mostly bonds. Sure, that might not be what many experts recommend, but if that’s what you’re comfortable with, that’s what you should stick to. If your investments make you feel uncomfortable, then you are taking on more risk than you probably should.
You Can’t Have Your Cake and Eat it Too
What I find is that most people take on more risk than they are comfortable with when the markets are doing well, and don’t take enough when the markets are struggling. The problem is, you can’t base your risk tolerance on which direction the economic winds are blowing. If stocks are good and you decide to allocate more of your portfolio to stocks, ask yourself if you’d be comfortable with this allocation if the market was doing poorly. If you know that you couldn’t stomach that much stock in a down market, you’re setting yourself up for disaster by altering your risk tolerance.
The whole point of minimizing risk through diversification is so that you have a portfolio that performs as well as it can with the least amount of risk. The purpose of asset allocation is to capture as much of the upside potential while minimizing the downside. It is virtually impossible to try and beat the market by making changes to your allocation based on past performance, which is what most people do.
Allocations Aren’t Set in Stone
All that being said, it is important to remember that your asset allocation isn’t permanent. You will want to make adjustments to your investments over time, and that is fine. But you shouldn’t be making wholesale changes at the drop of a hat. Your risk tolerance will change over time, and you will probably want to take advantage of some market trends to bolster your portfolio. But if you are making large adjustments based on what has happened over the course of a few months, you’re setting yourself up for failure. If you couldn’t predict that the market was going to turn south back in October, what makes you think you’ll be able to change your investments again as soon as the market begins its rebound?
Don’t let the market control you. If the losses in your account has you in a panic, then it is time to reassess your investments. Maybe you are investing outside of your comfort zone, and that’s fine. But before you make any changes, make sure that you’re comfortable with the investment mix in both good times and bad. Constantly changing your allocation as a reaction to something will almost always result in buying high and selling low, and I don’t think that is how you make money.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.
The bear market has been a great way to learn to accept risk. I've really had to come to terms with the fact that drops aren't the end of the world, but ditching my holdings at every drop just might be the end of my portfolio growth.
That's right, Ron. People often confuse market volatility with risk just because it is getting all the media attention. It's funny how people will pitch a fit when they are down 8% YTD and think it's the end of the world, when you look at their account over the past three years and they were making money hand over fist. There will be ups, and there will be downs, and as long as you have a ways until you need the money and keep adding to it, you'll be just fine.
The risk that people always forget is the risk out outliving your money, which is very real for most people. If you think losing a few thousand dollars this year is risky, come talk to me when you're out of money at 70 and are forced to work as a Wal-Mart greeter or live off of food stamps. I know that isn't a risk you want to take ;)
Great post. People also don't need to confuse risk with volatility, even weekly, monthly, or yearly volatility. The "risk" is that you will see continual declines over very long periods, not ups and downs over the next week, month, or even couple of years.
Too many times I hear people say, "Oh, that's a risky investment. That stock has been going down for several months now." That isn't risk! That's volatility! It would be risky to buy bonds from a company on the brink of disaster. It would be risky to buy stock from a company that's weakly emerging from Chapter 11 with no cash on hand.
A lot depends on your investment horizon as well. It would be risky to buy XOM with the money you've saved for a down payment on your home when you'll need all that money in two weeks. It wouldn't necessarily be risky to buy XOM with your Roth funds when you're retiring in 30 years.
Seriously. My (who is very smart normally) is getting caught up in the hype and telling me I should be selling my stocks and buying gold. Talk about selling low and buying high. Other than keeping a larger emergency fund/cash savings, I'm sticking to the basics- fully funding my 401k and Roth IRA and keeping my investments in index funds + a few others. I'm only 25 and have no reason to sell soon so I'm not worried about the current down market. I wish more people would listen to the standard advice. It seems that once emotions become involved and the media and other sources continue to feed the craze- logic gets forgotten.