With the recent increase in volatility, people are again speculating where the US stock market is headed. At this point, the market has been rising for almost eleven years, far longer than the average bull market. Eventually, we are going to experience a bear market. But the fact remains that no one has a crystal ball…it could happen tomorrow, or it could happen in another three years.
Regardless, if you think back to 2008, bear markets can be very unsettling. They can be short or they can last years. Again, no one knows.
That’s why it’s important not to put your money on auto-pilot. Instead, you (or your financial advisor, if you have one) should always be actively monitoring your investments and managing your risk. And the closer you are to retirement, the more important that is.
Why? Well, if you’re young and have decades of earnings ahead of you, you can live through the ups and downs of the market. You’ve got time to recover.
But let’s say you’re five years away from retiring. Depending on your particular situation, a bear market now could cause you to delay retirement. Even worse, a bear market at the beginning of your retirement could damage your future income generating abilities by eating into your principal early.
Fortunately there’s things you can do to help protect your money and your peace of mind. Here’s four tips.
Tip 1: Revisit your risk tolerance
“Risk Tolerance” is one of the terms that you hear a lot in the financial world. It is supposed to mean your ability to tolerate risk. The problem is, that’s not an easy thing to measure. In fact, most people naturally feel more comfortable with risk during bull markets. Make sense, when the market keeps going up, it is natural to feel that stocks are a great investment. During bear markets, investors often report being much more cautious. This is where our emotions work against us, because after stocks go into a bear market, there is probably much less risk than if we buy when stock prices have been rising for years.
Fortunately you can learn your true risk tolerance through some deeper conversations with your advisor. You’ll realize there are actually many parts to that question.
First, what’s your financial ability to tolerate risk? If you have a spouse and kids dependent upon you, or if you own a business that is in a really cyclical industry, your financial risk tolerance probably is lower, no matter how comfortable you feel investing in the market.
The other part of the equation is your emotional ability to tolerate risk. This is the one that often swings with the market and can get us in trouble. We may decide that we’re more comfortable with stocks after they have risen and end up with a portfolio that is too concentrated in equities. We saw a lot of that in 2008, when most people got really hurt, simply because they found themselves overweight in US stocks at the worst possible time.
Then, when the bear market hits, most people get wary of stocks. As noted above, that’s actually the best time to buy stocks, if you’ve got a long time horizon.
This is where your advisor can help you with scenarios: how would you feel if you lost a certain percentage of your net worth? There’s software that can help this process too. All of it is very helpful as it can get you mentally and emotionally prepared for times of volatility. When drops happen, you’ve already walked through some of those scenarios, so it can make it less intimidating.
Tip 2: Rebalance regularly.
In the dot com crash many years ago, and in 2008, most people experienced large losses. Why? They had probably had gains in certain stocks. As a result, they probably found themselves holding large positions in tech stocks or US large cap stocks. Making it worse, many times index funds or funds that may be sitting in your 401(k) at work may also be heavy in those holdings. As those assets increase in value, they end up being way too big a portion of your holdings.
When the market turns, those “leaders” usually are the ones to fall most, creating outsize losses. Fortunately, there’s a way to help prevent that, and it’s called rebalancing.
Rebalancing is something you should do at a regular interval and involves putting your portfolio back in balance. So if that means 50% stocks and 50% bonds, then you need to sell down your winners and buy more of the losing assets to get back to your ideal allocation (and your risk tolerance)..
In the process, you’ll find yourself automatically “selling high” and “buying low”.
While not perfect, rebalancing is vital to help you stay disciplined and avoid taking too much risk.
Tip 3: Keep saving and investing through volatility and bear markets.
One big problem is that when the market drops, like it did in 2008, most people go into “wait and see” mode. They stop investing new money. Instead they may wait until the market recovers. Sadly they are missing a huge opportunity to “buy low”, and instead they end up waiting and buying higher.
Without a crystal ball, nothing’s perfect, but consistently adding money to the market is a great way to even out your buys and sells. You’ll automatically buy more when things are cheaper (for example, during a bear market) and buy less when stocks are more expensive.
It’s a simple matter of staying disciplined and learning to ignore the fear that may stop you from consistently investing.
Tip 4: Consider diversifying with alternative investments.
After a long bull market, another option is to diversify your holdings further. If you’ve got plenty of time to recover, you may not need to. But for those with larger portfolios and those approaching retirement, one way to add stability and balance to your holdings is to add something called alternative investments.
Alternative investments are generally things that tend to move independently of the stock market. So if the stock market continues up, your “alternatives” may drop, but if we experience another 2008, the alternatives will likely act as a shock absorber.
What are alternative investments? These can include real estate, private equity and venture capital, gold and silver, and commodities. Also some financial firms have developed some “synthetic” alternatives by creating funds that are designed to serve as alternative investments in your portfolio.
Handled correctly, these can provide balance and even out your returns over time. Work with your financial advisor to evaluate products and see what is right for you.
Tip 5: Consider real financial advice to help you avoid expensive mistakes.
In 2008, many people were caught overweight in US equities, and as a result, suffered steep losses. Many of these people had advisors, too.
This highlights that all financial advisors are not created equal. Many are primarily product driven, and their business model incentivizes advisors to focus on selling, as opposed to providing sound financial planning.
To build wealth that lasts, most people are best served by getting real financial advice. That usually means finding a fiduciary, and looking for one that provides fee-only advice, to avoid the conflicts of interest.
Follow these tips, and you can find yourself less reactive to the inevitable ups and downs of the stock market.
John Odell, CFP® is CEO of Arroyo Investment Group, LLC, a GIPS®-compliant, fee-only wealth management and financial planning firm based in Southern California and serving investors nationwide. Contact us to arrange a free, no-obligation second opinion on your portfolio.
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