YOUR TIME HORIZON, human capital and the other bond-like income streams in your life might suggest you should invest heavily in stocks. These aren’t the only factors to consider, however. Suppose you’re a unionized government worker with 25 years to retirement. At first blush, it seems like you ought to invest most of your money in stocks.
But before you dive into the market, give some thought to how much risk you need to take to reach your goals—and how much risk you can stomach. Even if your job situation suggests you can take a lot of investment risk, you might hold a more conservative portfolio if you’re already well on track to meet your various goals. More important, you shouldn’t take a lot of risk if you are uncomfortable with wild fluctuations in your portfolio’s value. The danger: Stocks dive, you sell in a panic and you end up locking in your losses at the worst possible time.
Personal risk tolerance is tricky to assess because it changes over time. When markets rise, we often grow more bullish as we extrapolate those gains into the future and we attribute our fattened portfolio to our own brilliance. We may also feel we can take extra risk because financially we’re ahead of where we expected to be. But when markets plunge, these good feelings can evaporate, and we often grow less risk tolerant. To get a sense for how risk tolerant you really are, try to recall how you felt and how you behaved in late 2008 and early 2009. Did you sell stocks, sit tight or buy more? To refresh your memory, you might pull out your account statements from those years and look at the trades you made.
One trick for assessing your risk tolerance: Figure out what’s the maximum dollar loss you’re willing to suffer. Let’s say it’s $150,000. Next, divide that $150,000 by 0.35, which will give roughly $429,000. That’s the most you should invest in stocks. What’s the logic behind this calculation? In the typical bear market, stocks fall 35%. If you limit your stock holdings to $429,000, you shouldn’t lose more than $150,000 if we have a “normal” bear market. You could, of course, lose more if the bear market turns out to be especially severe—but your financial pain shouldn’t be too much greater.
Even if you have been a nervous investor in the past, you may discover you grow more comfortable as you become accustomed to the market’s craziness. While 20-year-olds should supposedly have a healthy appetite for risk because they won’t need income from their portfolio for many decades, often the investors who are bravely buying at market bottoms are wizened market veterans in their 50s and 60s.
Next: Step 2: Allocation
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