Even with 2008 ever more distant in the rear view mirror, investors still get reminded during most years – and already this year for sure – that stock markets can be a roller coaster.
Now that we’re between major downturns, let’s look at your investment risk tolerance in a different way, potentially drive some of the jitters out of investing and maybe allow you to seek more growth potential.
Risk tolerance as typically measured by investment advisers is the degree to which you are willing or able to accept fluctuations in the value of your investments. If your risk tolerance is low, you want conservative, stable investments. High risk tolerance means you’re fine with bigger short-term swings in exchange for more long-term growth potential.
Although the word risk implies danger of true loss, the U.S. stock market has been positive for 73 percent of the years 1927-2015, and all 15-year periods have been positive during that time. Sharing in market growth is as easy as owning a broadly diversified basket of stocks using mutual funds or exchange traded funds, as long as you see it as a long-term proposition.
But there are two ways you can actually lose money in the stock market:
1. Own stock in a single company that defaults; the stock value may drop to zero. That’s true loss. But it’s easy to avoid disaster: Don’t hold more than 5 percent (preferably much less) of your investments in any single company stock. Winners offset losers in a diversified portfolio, so owning a broad mutual fund or ETF does the trick by including dozens or thousands of stocks.
2. Sell securities for less than you paid. For example, buy a broad U.S. index fund when markets are doing well, then sell during a recession for a lower price per share. Again, that’s true loss.
So why do people “sell low”? Sometimes it’s an emotional reaction to a market drop – “I’m losing money, so I’m getting out now.” That’s understandable, but again it’s a true loss. The cure is to recognize markets always perform in cycles, and a lower account balance is not really a loss unless you sell. Hang on, weather the downturn, and don’t sell low out of an emotional overreaction.
But there is another reason people sell their investments low and lose real money: They simply need to raise cash. Retirees often fall into this camp – regularly liquidating part of their portfolio to pay the bills and have their fun. That was the plan, right?
But this version of selling low can also be avoided, with a simple math exercise to create a recession reserve.
First, market downturns are unpredictable, so assume the next recession starts tomorrow.
Next, understand that recessions tend to last six to 18 months; afterward, stock values start climbing back up – sometimes slowly, sometimes dramatically – in fits and starts. From the Great Depression in 1929 until the purchasing power of stocks returned to full value took about three years. The 2008 recession took over four years to play out. The average is three to four years (though one recession last century did take seven years until full recovery of values).
So, assume a five-year dip for a recession starting tomorrow, until stocks return to full value.
Now, how much cash will you need from your investments over the next five years (or seven years if you want to be extra cautious)? Stop right now, and figure that out. Got it?
OK, that’s how much you need to take out of the stock market, right now, and put into a more stable holding, for example an intermediate-term bond fund that won’t get hammered if the next recession starts tomorrow. This is your recession reserve.
When a market downturn comes along, simply draw needed cash from your recession reserve, instead of selling stocks to raise cash.
If your emotional risk tolerance is very aggressive, this simple math approach can help you prevent being overweight to stocks and putting your financial plan in potential danger. If you’re a conservative investor and know you need more long-term growth to meet your goals, this can help shelter a correct amount of assets – but not more than necessary.
The recession reserve strategy may help you worry less about market dips and allow you to participate more in the growth potential of the capital markets if you wish – instead of allocating your portfolio based merely on your age or on a negative emotional reaction to inevitable market swings.
Always work closely with your financial adviser for the right balance between what the math says you can do and what your gut says you should do to sleep well at night. And be sure to re-evaluate each year to make sure your recession reserve is adequate.
Kenny Gott is a certified financial planner with Piatchek & Associates Inc. He can be reached at kgott@pfinancial.com.
