By determining how much risk is appropriate in your portfolio you are taking steps that will help you guard against panic and regret during the next bear market.
Remember the bear market from 2007 to 2009? Where the U.S. stock market, as measured by the S&P 500 Index, dropped by more than 50%? During those dark days many physician clients wanted to sell their stocks and exit the market — exactly the wrong thing to be doing during a bear market.
While the adage is, “Buy low and sell high,” fear and panic can drive people to do the opposite by buying high and selling low at market bottoms; in effect, locking in that loss and a permanent impairment of capital.
With the stock market reaching new highs every day, it’s easy to become comfortable in your financial routine and skip planning for the future. However, you should be using this time to take a step back, learn how much risk your portfolio has, and assess if it’s at an appropriate level of investment given your circumstances.
Even if you weathered 2007 to 2009 well and did not panic, we are all five years closer to retirement and hopefully our portfolios are larger. This means, there is more to lose if the market drops and less time to make the loss back.
So, how can you help avoid this mistake when the next bear market (defined as a drop of 20% or more) inevitably comes around? Just consider following these three key steps:
1. Measure your risk tolerance
Risk tolerance is the psychological measure of how much risk an investor prefers to take. Contrary to what many people believe, risk tolerance is a relatively enduring way that one individual differs from another and it is stable for each individual.
What often changes is an individual's perception of market risk, and during bear markets, people often flee the stock market because they perceive the risk as being greater than they did when the market was doing well.
2. Take a validated risk tolerance questionnaire
Each member of the couple should take a validated risk tolerance questionnaire separately and then see how their answers align so that any mismatches can be addressed before proceeding to construct the portfolio. The answers to the questionnaire often provide a good starting point to a discussion about risk tolerance, too.
3. Establish a written Investment Policy Statement (IPS)
This document outlines how much risk the portfolio will contain. An IPS provides a touchstone. At times like this, with the markets making new highs, it may lead investors to trim some of the riskier holdings as we are five years into a bull market and risk levels have risen. At the depths of the next bear market, returning to the IPS will help ground you and keep you from selling out in a panic.
Determining how much risk is appropriate in your portfolio depends on a number of factors, including your tolerance for risk, age and time horizon. By doing so, you are taking steps toward creating a healthy portfolio that will help you guard against panic and regret during the next bear market.
Joel Greenwald, MD, CFP, is a physician-turned financial planner who exclusively provides financial advice to doctors. He has written many articles and been a frequent speaker on how physicians and dentists can achieve long-term financial security. More about Joel and his firm, Greenwald Wealth Management, can be found at www.joelgreenwald.com.
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