The last seven weeks have obviously been tumultuous for the stock market (would gut-wrenching be a better word?). Is it over? Are we coming close to the end of this awful roller coaster ride? I wish I had a crystal ball that could answer that. Last week’s rally offered investors at least a temporary respite, and a couple of my favorite financial writers had a few thoughts. Jonathan Clements suggests using this moment to “think about the market’s recent rollercoaster ride—and how you’ve handled it emotionally.”
Clements noted that financial experts distinguish between risk capacity and risk tolerance. It’s a useful distinction. Risk capacity is our objective ability to take risk based on our personal situation, notably the reliability of our paycheck and our investment time horizon. The most important rule: If we have savings that we’ll need to spend over the next 2-5 years, that money should be in conservative investments, not stocks or riskier bonds.
Meanwhile, our risk tolerance is our emotional ability to weather market turbulence—and it’s a reason we might keep less in stocks than our risk capacity allows. But how much risk can we tolerate? It’s an issue that has long confounded experts.
So, if you’re thinking about reducing your exposure to stocks during a bear market, Christine Benz, Morningstar’s director of personal finance, has a few questions you might want to ask yourself:
#1. How soon will you begin spending money if you are still working? This a key question as you decide whether you need to “de-risk,” even after your portfolio has tumbled. The closer you are to drawing down from your nest egg, the less time you have to let the stock market recover. But, if you are 2-3 (or more) years away from withdrawing money, that’s probably enough time to let this market get past the Coronavirus issue. The average market rebound is 18 months.
#2. Hand-in-hand with above question is, “How flexible is your retirement date and how much do you need to spend?” Obviously, it’s a good time to cut spending (I personally find that practicing “social distance” is providing a side benefit of spending less.
#3. What is your asset allocation now and is it suitable? If you are invested in 60-70% stocks, that means you’ve probably got 30-40% in more stable, fixed income-type investments – that haven’t had the volatile swings the stock market has given us. How much do you spend annually? Would that 30-40% invested in fixed income cover this annual spending for the next 2-5 years (again allowing us time for a market recovery)?
#4. How viable is your long-term game plan? We run retirement cash flows for most of our clients and then stress-test the results. This type of planning can be especially valuable during turbulent times and can help provide an additional layer of confidence.
- One of the tests is called “bad market timing” and poses the question, “What if the next two years of market performance are really ugly? How is my personal situation affected?
- The other “stress-test” we do is running 1,000 hypothetical situations (including a situation as rough as or worse than we’ve seen in the last few months). The software then assigns a probability of success that your cash flow is adequate to provide income for the rest of your life.
I consider it part of my job to not only help you answer the questions above, but also make rational decisions during both the good times and bad.