OUR PORTFOLIO’S BASIC split between stocks and more conservative investments—its asset allocation—is the most important investment decision we make. Too often, folks make this fundamental choice based on some hunch about the stock market’s short-term direction. Alternatively, they back into the decision, buying a hodgepodge of investments and never formally settling on an asset allocation.
Want to do it right? We should think about how much risk we can reasonably take and how much risk we can stomach. In Wall Street speak, this is sometimes referred to as “risk capacity” and “risk tolerance.”
Risk capacity is an objective assessment of our ability to shoulder risk. It’s usually based heavily on how far off our goals lie—if we have decades until retirement, stocks should figure prominently in our portfolio—but other factors also come into play, most notably our job security. If there’s a chance we’ll lose our job and need to tap our portfolio earlier than expected, we should probably take less investment risk.
Meanwhile, risk tolerance is about how much risk we’re comfortable taking. That’s far harder to figure out, especially if we’re new to investing. The portfolio we’re happy to hold during a booming stock market may give us sleepless nights when share prices turn lower. Often, to get a good handle on how much risk we can tolerate, we need to live through a bear market, and perhaps more than one.
Is there any way to increase our risk tolerance, so we’re less fretful during falling markets? Consider two strategies. First, when share prices plunge, we might focus not only on the amount we currently have invested in bonds and other conservative investments, but also on the cash that we’ll be investing in the years ahead.
Suppose you’re age 40 and have a $100,000 portfolio, all in stocks. Risky? Let’s say you earn $60,000 and save 12% of income, or $7,200 a year. Between now and age 65, you’ll add $180,000 in new cash to your portfolio, dwarfing the sum you currently have in stocks and arguably making your financial situation quite conservative.
What’s the second strategy? We should own stock investments in which we have great conviction. When the market plunges, there’s no guarantee that any particular stock or industry sector will bounce back. But history tells us that the global stock market eventually recovers and goes higher.
In other words, the more diversified our stock portfolio, the more confidence we should have. Want the broadest possible stock diversification? Consider purchasing total stock market index funds that give you broad exposure to both U.S. and international stock markets.
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