ARISTOTLE WROTE THAT, “It is a part of probability that many improbable things will happen.” Investors certainly understand this. For better or worse, we know that the market has frequent ups and downs. On average, the S&P 500 has dropped 10% or more approximately every 18 months, and it’s dropped more than 20% about every four years.
Unfortunately for investors, another fundamental truism also applies: We dislike losses disproportionately more than we like gains. Harry Markowitz referenced this notion in his 1959 monograph. In 1979, Amos Tversky and Daniel Kahneman developed the idea more fully, calling it prospect theory.
This leaves investors in a tough spot. On the one hand, we know that markets don’t move up in a straight line. Far from it. But at the same time, we hate it when we see our investments decline in value. The result: Disappointment is almost guaranteed.
It can be especially unnerving if you’re further along in your career—or are retired—and the numbers are larger. Suppose you started 2022 with a $5 million portfolio, allocated in a reasonably conservative 60% stock-40% bond mix. With the U.S. stock market down about 8% year-to-date, your portfolio might be down about $240,000 at this point ($5 million x 60% x 8%). Even though your portfolio might have gained several hundred thousand dollars last year, it’s natural to focus only on a portfolio’s high watermark and on where things stand relative to that peak.
As a result, the cycle repeats: We invest in the stock market because we know that, on average, it’s been a reliable way to build wealth. But then, just as reliably, the market drops, giving investors a collective stomachache and leaving them to wonder when things might turn positive again. Eventually, the market does recover. But then, often without missing a beat, our worries shift. We start worrying if the market has gotten too high again. And so it goes on. While this pattern is as old as markets themselves, the past two years have provided a microcosm of this psychological rollercoaster. If you’re feeling fatigued by it, I don’t blame you.
Other than reaching for the Mylanta, what steps can you take to make the investing process less exhausting? In the past, I’ve suggested a few ideas. For starters, ignore the purveyors of so-called alternative investment funds. The research firm Morningstar has studied funds like this and concluded that they’re a little like the tooth fairy—nice in theory, but generally not realistic in practice. Another simple strategy, which I described last week: Look for ways to build—or even just to identify—margins of safety in your financial life.
What else can you do? One silver lining of a market downturn: It gives investors an opportunity to conduct stress tests. With the overhang of inflation at home and war abroad, 2022 has gotten off to a gloomy start. The reality, though, is that the U.S. market is still only down about 10% from its peak. And it’s up more than 10% compared to where it was a year ago. That makes this a good opportunity to revisit your portfolio’s risk level and reassess your comfort with it. If this year’s losses are just a blip on your radar, that’s great. But if you’ve been losing sleep, consider this modest drop as an opportunity. If you decide to reduce risk, it’s far better to make that change when your portfolio is down just 5% or 10%, rather than when it’s down 50%.
If you want to revisit the risk level in your portfolio, I’d start by asking yourself two questions.
First, how much risk do I need to take? Investors saving for long-term goals generally need to have some stock market exposure to provide growth. But how much you need depends on your specific goals. Try to estimate how many dollars you’ll need for each goal and in how many years. If you know those numbers, that will allow you to work backward, so you can determine the absolute minimum investment return you’ll need to get there. That, in turn, can help you determine the minimum you’d need to have in stocks to achieve that return.
Second, how much risk can I afford to take? If you’re early in your career and saving for retirement far in the future, the answer to this question may be simple: You might be able to take as much risk as you want. But as you get older and closer to your goals—and especially once you’re actually in retirement—you’ll want to cap your stock market exposure. That will allow you to meet your goals regardless of whether the market is up or down in any given year. For example, if you need to withdraw $50,000 per year, I’d suggest maintaining a minimum $250,000 to $350,000 outside of stocks at all times.
To the extent that those two questions provide different answers, that’s okay. That’s true for most people. You might calculate that you need a minimum 40% in stocks but can afford a maximum of 70%. How would you decide where to situate your portfolio on the spectrum in between? To answer that question, I suggest one more calculation.
For each possible asset allocation, I’d calculate the potential maximum loss in a bear market. Suppose you were considering a 60% allocation to stocks. If share prices were to drop by 50%—as they did in both 2000-02 and in 2007-09—your portfolio might drop by 30% (50% x 60%). If you have a $1 million portfolio, that would imply a $300,000 loss. If you have a $5 million portfolio, the potential loss would be $1.5 million. It’s useful to translate percentages into dollars because, in my experience, each person has their own threshold for acceptable dollar losses, plus thinking in dollars makes the risk feel more real. Going through these scenarios can help you uncover where that point might lie for you.
In his book One Up on Wall Street, Peter Lynch provided a set of illustrations to help investors understand the nature of the stock market. For each stock, he made a chart of the share price over time. Then he would overlay a chart of the company’s profits. In each case, a clear pattern would emerge: Over the long term, a company’s stock price generally followed its profits. That was the big picture. But in any given year, the share price often became disconnected from the company’s profits. Sometimes, the stock price got ahead of the company’s earnings, and sometimes it fell behind.
On paper, it was clear that the two lines would likely reconverge. But in real life, when investors are in the midst of the market’s daily swings and the headlines are full of bad news, emotion tends to take over. That can make it hard to see the big picture—to believe that the two lines will, in fact, converge again. That’s why my final recommendation is to take some time to study market history. That, I think, can help investors better see the market for what it is: logical over the long term, but often irrational in the short term.
Investment advisor Michael Batnick sums it up well. “Try not to get too excited on up days and too despondent on down days,” he wrote. “The market’s gonna go where it’s gonna go and you need to preserve your mental capital.”