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WHEN MARKETS PLUNGE, investors start questioning whether they have the right mix of stocks, bonds and cash. That’s no great surprise: Bear markets hammer home the investment risks we’re taking—and many folks discover their portfolio is too aggressive for their taste.
That’s a useful insight for the future. But it’s hardly one you want to act upon when, even after Thursday’s rally, the broad stock market remains down some 16% for the year-to-date and the bond market is off 14%. My advice: If you’ve learned in 2022 that your risk tolerance is far lower than you imagined, try mightily to hang tough until the stock and bond markets recover. To that end, you might ask yourself these five questions:
1. What’s my true net worth? As Austin Dorenkamp noted in his article earlier this week, our net worth includes not just our stocks and bonds, but also real estate, bank accounts, vehicles and more. When we look at the big picture, we may find that our portfolio losses in 2022 are relatively small—and not nearly so distressing.
2. How much do I have in bonds? Arguably, we should expand our definition of net worth, and include all the bond lookalikes in our financial life. I’m talking about things like current or expected Social Security payments, current or expected pension payments, and—most important for those still in the workforce—the value of our human capital, which is our income-earning ability.
It’s tricky to put a value on these bond-like streams of income, but they are indeed enormously valuable. Add them to our net worth, and this year’s market losses will seem even smaller.
Feeling cheerier? Before we get too cheery, we need to look at the full picture, and that means subtracting our financial life’s negative bonds—the debts that we have, where we don’t earn interest but rather pay it to others. A silver lining of today’s rampant inflation: These debts are now less of a burden in inflation-adjusted terms.
3. How much will I save in the years ahead? As I’ve argued before, we can think of future savings as part of our portfolio’s cash holdings—and that future cash makes our investment mix more conservative than it might otherwise seem.
Expect to save $150,000 between now and when you retire? Think of that as $150,000 in cash sitting in your portfolio and helping to soften today’s investment losses. An added bonus: Including future savings offers a quick-and-dirty way to factor our human capital into the value of our portfolio.
4. How much cash will I need from my portfolio over the next five years? Many folks, including me, advocate getting money that’ll be needed from a portfolio over the next five years out of stocks and riskier bonds, and into nothing more adventurous than short-term bonds. The rationale: While a bear market may drag on for longer than we’d like, we should see some sort of recovery before five years are up.
So, how much cash do you need from your portfolio over the next five years? If that money is already sitting in conservative investments, there’s no compelling financial reason to sell stocks or riskier bonds at today’s depressed prices.
5. What’s my time horizon? Yes, we might spend part of our savings over the next five years. But I suspect most readers have no intention of touching much of their portfolio for 10 years and probably longer—and that includes retirees.
Remember, while buying a home and putting a kid through college are financial goals with harsh deadlines, retirement is a different beast. We might spend down our nest egg over 30 years—and most of us aren’t aiming to get to zero by the time we shuffle off our mortal coil, because that would make our final years simply too nerve-racking.
Yes, this year’s investment losses have been painful. Yes, many folks now wish they had a less risky portfolio. But how many of us have such an immediate need for spending money that we’re compelled to sell at today’s prices? I strongly suspect there’s hardly anybody in that camp.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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This is how I’ve learned to determine my risk profile over the decades.
Am I investing according to my Willingness, Ability and Need or am I timing the market, buying the dip. hoping for a home run and scrambling to raise cash to pay the bills?
Ability to take risk relates to time horizon, human capital, years left in the workforce, income & liquidity requirements and overall financial resources. Its rational & quantitative like numbers in a spreadsheet.
Willingness to take risk measures gut-level appetite. It’s the difference between the desire to grow wealth and to protect it. It’s the opposite of Ability as its irrational & qualitative like Greed & Fear. Can be measured by the “SWAN Index”. When the markets are tanking can I still Sleep Well At Night?
Need to take risk as measured by the minimum rate of return required to reach a goal. It’s an aspirational expectation. If you’ve already Won the Game then your need is low. OTOH, if you need 25% returns for each of the next 10 years then its much too high.
A+W+N as a way to determine risk sure does make sense. The issue I have is my own self-deception, where my mind plays tricks and does not apply A+W+N properly. During bad times the mind suppresses AWN while it aggrandizes it during good times.
Ray Dalio makes a big deal about meditation in his writings. Apparently meditation helps him observe the mind from a distance, to see reality without the ego getting involved. So i guess this means he was able to assess and apply AWN accurately.
Unfortunately, my mind is lazy, lacking the gears for clear thinking, far to restless for meditating, and thus I always end up resorting to the plain wisdom rules of thumb as I’ve written below.