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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.
I am not a sophisticated investor so I must admit I rely a lot on plain wisdom we’ve inherited over the ages.
Here are a few obvious ones that come to mind and how they’ve formed my investing philosophy.
Don’t put all your eggs in one basket – diversify
Always take the high road – quality investments
Take the middle path – 50/50 stock/bond
Don’t scheme – don’t try to outsmart the market
Always be prepared – save early & have insurance
Don’t be jealous – avoid crypto & FOMO
Be honest – don’t make $ by cheating others
Safety first – have plenty Treasuries/I Bonds/Cash
Work hard – add value at work
Be greedy when others are fearful – thank you Warren.
Yes, this whole thing is rather Forest Gumpy, but it has guided me and I’m doing rather fine through this market turmoil. No reason to consider jumping.
As Jonathan has reminded us, most of the stuff we hear on the news and the stuff Wall St. cooks up is best ignored. Just stick to these rules and you’ll be ok.
Getting granular, consider the following.
Regarding human capital, post-retirement or due to medical reasons at any age, monetizing human potential my not be in the mix.
Even in a 4.5% CD, cash depreciates due to inflation. So do assets such as cars.
Negative bonds would include insurance. This year’s homeowners insurance bill was ridiculous (or maybe not according to the insurers because of increased costs of construction). Other costs too, such as energy.
The election a few days ago resulted in a reprieve of attacks on Social Security. But consider that political rules have changed such that down the line this could effectively become a bond in default.
If might also be affected by the amount of money you have. For example, if you have saved 100 times the amount you need, then your planning could be different. You could take more risk. If your investments go down 50 percent, you still have 50 times the amount you need. If you’re coming in on “a wing and a prayer” then you need a completely different approach. Anyone who has their entire net worth tied up in a business they own has another altogether different challenge.
In this bear market, I have to wonder if those who feel that their portfolio is too risky, and take steps to alter their investment mix to make it less risky, will rue that decision in the next bull market.
Our risk tolerance waxes and wanes with the market’s gyrations. A risk tolerance questionnaire, rather than measuring a personality trait, is perhaps more of a snapshot in time — subject to change when circumstances change.
Shifting to a more conservative asset allocation during a bear market is little different than making knee-jerk decisions in other areas of life when we’re emotional after some real or perceived misfortune.
When we begin our investing careers, we seek to determine an appropriate asset allocation for our financial goals. Then we consider that we might have been in error and make adjustments when market conditions don’t suit us. Such a shame. Behavioral finance economists must enjoy the job security.
I recently put my prospective Social Security benefit into an immediate annuity calculator to determine the future worth of that stream of income. When you convert it to a lump sum, and of course the calculation didn’t account for COLA increases, it does make you feel as though you have more assets.
Financial planning for a survivor is important too. Would you include whole/paid up life insurance as part of net worth in that context?
Sure, if you have the misfortune to own a cash-value policy, by all means include it!
It isn’t necessarily a misfortune. My grandparents had one of these policies. They got it because when my grandfather left an employer circa 1970, they gave him the policy they had taken out on him. I cashed out what was left of it to pay for some of my grandmother’s end of life expenses.
So count everything!
I was thinking of the amount of insurance that will be paid upon death.