People always ask me what they should do about the stock market. As a financial professional, I don’t prognosticate about the market or make economic forecasts. My job is to help people achieve their financial goals and dreams, no matter what happens in the market.
For many people, their “financial plan” is little more than the asset allocation and performance of their portfolio, which is backwards. If the market is up, people make comments about retiring early. If the market’s down, they complain that they will be working forever. If your financial plan is done right, when you retire should have nothing to do with the performance of the stock market.
By nature, the stock market is volatile. JP Morgan has a great visual that explains this. Over the past 38 years, through 2016, the market experienced an average of a 14.2 percent drop in value at some time during the course of each year. Yet, it ended the year higher than it began 28 out of those 38 years, or 76 percent of the time.
When markets look scary, the initial reaction is often to pull out of the market. That could be a huge mistake. As the study points out, six of the ten best days in the market occurred within two weeks of the ten worst days in the market. If you sell out on those worst days, you will more than likely miss the best days.
You can’t control the market, but you can control your behavior.
It all comes down to your tolerance for financial risk. Most people have no idea of their risk preferences, or why they own what they own in their portfolio. We’ve all seen the risk questionnaires you have to fill out when you open an investment account — whether you are aggressive, conservative, or in between — but people really don’t know how to answer those questions. I’ve been using a tool with my clients, which works well in helping people understand how their tolerance of risk aligns with their financial plan and their portfolio.
The assessment starts with up to 15 questions that quantify how you feel about risk, loss, and gain, with actual numbers. Then, it assigns you a risk number on a scale from 1 to 100, where 1 is completely safe and 100 is highly risky.
Of course, that number has no meaning until you compare it to the risk number of the person’s portfolio. A client may have a risk number of 33, but we might find their portfolio has a risk number of 63. This might lead to a discussion of how a portfolio at 63 might perform in the market, good or bad, as opposed to their risk number of 33. Then, we can design a portfolio that’s more closely aligned to their personal risk number. Behaviorally, the client ends up having a much better understanding of why they own what they own, and its upside and downside risk.
While it is satisfying to be able to quantify your feelings about risk as a tangible number, your risk profile and that of your portfolio should be seen as merely components of a much larger financial plan. Your financial plan should never be based on whether you get a four percent versus seven percent return, because you’re going to get the returns that you get. You can’t control the market. What you can control is your behavior and how much you save and spend.
There are three steps involved in creating this plan:
- Knowing what you are trying to accomplish, financially and personally
- Having a written plan of action on how to accomplish it, no matter what happens in the market
- Staying the course on executing that plan
Back to our original question: What should you do for the next market downturn? It’s not a matter of if it’s going to happen, but when and how bad. What you should do now is hold a “fire drill,” don’t wait until the house is burning down. First, ask yourself about your goals, objectives and opportunities. Second, figure out what your personal risk number is, and whether your portfolio is aligned with your risk tolerance and make changes now. It’s tough to walk away from things when they’re doing well, but, as we’ve learned, that’s the best time to do it.
Then, when the market does take a nose dive, my advice would be to stop watching TV. Stop reading the paper. Get a hobby, work in your garden, or go for a walk. If you think about the market at all, think of the downturn as an opportunity to buy in at a much lower price. Everybody loves a good sale.
Curious about your personal risk number? Take the questionnaire here.
Risk Management is only one aspect of a sound financial strategy. All investing involves risk, including the potential loss of principal, and there is no assurance that any financial strategy will be successful.