This article originally appeared in the Knoxville News Sentinel’s business column on August 19, 2018.
The sky is falling, the sky is falling. Sell, sky! We’re all waiting for the next stock market correction. I received another email this week asking, “Isn’t it time for a big collapse? Should I sell?”
There are a number of factors to consider regarding asset allocation. At the top of the list is your risk tolerance, followed by needs and expectations. Understanding how to cope with risk tolerance is critical. I once worked with someone who had different “buckets” of money. He took the interest from retirement plan contributions and created a separate bucket within the retirement plan account. That interest bucket was then allocated to stock investments. On Monday, October 19, 1987, when the market had a 22.6 percent decline, I called to console him. By that point, his stock account had grown because interest rates had been very high so the stock portion equaled about half of the account. Even though he had low risk tolerance, he wasn’t concerned. He said, “Oh, my contribution money is safe in CDs and bonds. That was only the interest money so it’s okay.” He had found a way to compartmentalize his risk tolerance. We often talk about making sure your cash needs for the next three to four years are met in investments that don’t fluctuate in value. That methodology ensures you won’t be forced to sell at a time when the stock market is down. No one likes to see losses in the market, but it’s even worse if you’re forced to sell during a downturn.
Market volatility has been very low over the last few years. In 2017, there were only eight trading days when the S&P index was up or down more than one percent. In the first quarter of 2018, there were 23 such times. People generally remember with greater clarity and assign more weight to recent events, particularly negative ones. Historically, the market averages a five percent decline six times per year. If we are indeed returning to normal volatility in the market, it is important to remember two things: Number one, prudent and thoughtful diversification remains critical to protecting capital, and number two, emotional reactions to the shock of volatility can be seriously detrimental to long-term returns.
Determining your own risk tolerance is critical to avoiding knee-jerk reactions. It might improve your sleepless nights when you accept that a one-day five percent decline is actually likely, not unlikely. Making sure you have assessed your own “sleep at night comfort level” helps determine what’s right for you; not necessarily for your neighbor, drinking buddy or the Wall Street guy. After you’ve defined your tolerance for risk, be sure to adjust your portfolio accordingly. After all, money should meet you at the intersection of your comfort level and expectations.