So, as you may recall, a little over ten years ago the world went through this little experience we commonly refer to as “The Financial Crisis.” It was also called “The Great Recession.” Boy, did it feel great. As in, like the “Great Depression” great. The kind of great where you worry that everything is going to fall apart.
Happily, things didn’t fall apart. Thanks to a whole lot of government bailouts 🙂
By the way, there’s an excellent movie called “The Big Short,” which is hilarious and entertaining and shows us commoners what the hell happened to cause the Crisis in the first place.
Anyway, today’s topic is about the choices of individual investors, not about the Financial Crisis. One thing I have learned from my investing research is this: when the markets are down, people learn how solid their financial plan really is. More specifically, they learn whether their investments actually fit their ability to handle risk. As Rick Ferri writes in his book “All About Asset Allocation,”
“When a person overestimates his tolerance for risk, a bear market like the one in 2008 will expose his misjudgment.”
“All About Asset Allocation,” by Rick Ferri p277
In other words, when the bottom falls out of the market, people learn how much risk they can actually stomach. If the fear of loss overcomes them and they panic, they may do something they regret later, such as selling all their assets at rock bottom (Hint: you don’t want to sell your assets when they are cheap. You want to buy them when they are cheap, and you want to sell them when they are dear.)
In fact, I know several people close to me who pulled out as the market was collapsing in ’08, concerned about their shriveling portfolios. They lost a lot of money because they did not understand the principles of buy-and- hold investing (which by definition sometimes can include holding on for dear life!).
Also, they had simply taken on too much risk. Sadly, by selling their investments at a low point, they locked in their losses.
I wasn’t personally invested at the time of the Financial Crisis, so I did not live through it as an investor . Yet I did live through it as a human, and indeed it was intense!
These past few years since starting to invest, I have often wondered what my actual risk tolerance would be in a situation like what we went through over ten years ago. Some questions I ask myself:
- If the market were to dip 20%, 30%, 40%, or more (!), how would I feel? Would I be able to keep my cool, watching my investments take a temporary nose dive and hanging in until they recover?
- Is my exposure to stocks the right exposure for me? (I’m currently almost completely stocks) Should I consider more bond ownership for diversification? Will that make the ride less bumpy in the event of a dramatic bear market? Or would I regret the possible lost growth?
- They say that stocks are supposed to give the highest returns in the long run. So if you have a long time horizon (like 25+ years, as I have before normal retirement age), you are supposed to be able to afford to live through the peaks and valleys in the stock market and still end up way ahead. That is all well and good, but in actual practice, what is it like to go through those peaks and valleys? Will I be glad I rode it out, or will I wish I had gotten off that bucking bronco of an equity portfolio and chosen the gentler, mellower mare of bonds?
- What is the right balance of investments for me? In other words, what is my ideal Asset Allocation?
At its root, asset allocation is the process of finding out the answer to all these questions. It is about discovering for yourself what you truly value as an investor, and setting your course accordingly. For instance, it is possible that you are intensely growth-oriented. You really want to see your portfolio grow, and you are willing to crash and burn a few times to get there. You are what they consider an “aggressive” investor.
On the other hand, you may be worried mostly about losing your money. You may want to hold onto that principal for dear life, absolutely committed to preserving it as much as possible. You may even question whether you should buy stocks at all. You are considered a “conservative” investor.
I admit, I like to think of myself as willing to be a risk-taker when it comes to investing. I like to think that I am ready to ride that bucking bronco, assured of great rewards on the other side. Yet, when I consider the downside, I don’t feel good. I don’t like the idea of my portfolio losing a lot of value. Yes, I don’t worry about a temporary 20% drop in asset value. I could handle 30%, for that matter. It doesn’t sound fun, but I think I could stomach it.
Yet the prospect of losing 40% or 50%, even for a little while… how would I react to that? Generally speaking, I don’t think I’m quite as emotional about investing as some people might be. Yet I haven’t really lived through a bear market (let alone, an intense, dramatic one like in ’08!) with my money actually invested. I don’t really know what that is like.
And I don’t savor the prospect of seeing my portfolio collapse in such an event. A part of me questions the wisdom of taking that risk.
I’m sure time will tell which type of investor I am: the aggressive one, or the more conservative one.
Hopefully, by asking myself questions like these, I will make the right choices for me.
Hopefully, I will be prepared.