Don’t Let the Stock Market Dictate Your Risk Tolerance
The S&P 500 is up more than 16 percent so far this year; the Dow Jones Industrial Average has broke the psychological 15,000 barrier; and everyone seems to be making money in the stock market again. So it looks as though the economy is back on track, and many who have been avoiding the market want to be in stocks again. But this sudden euphoria can be hazardous to your wealth if you let the market dictate your risk tolerance. It’s a mistake to increase your risk tolerance when the market is up and decrease it when the market is down. It’s times like these when diversification and a well-crafted financial plan are critical.
During the dot-com era, very few people owned bonds or dividend-paying stocks. The rationale was, why own a boring bond or an outdated company like Coca Cola when technology stocks were returning double-digit returns? It didn’t matter if the tech companies were not making money, investors continued to buy only tech stocks. As tech stocks soared, investors didn’t rebalance their portfolios to reduce risk, and they became overly exposed to a handful of stocks. When the tech bubble finally burst, these individuals lost more than half their money and lost faith in the financial markets. However, those investors who had developed a comprehensive financial plan with policy limits and stuck to their plans came out ahead.
Fast forward a few years and during the 2008-2009 financial meltdown, investors fled to safety. No one wanted to own stocks, and investors who had previously said they wanted to take risk were now saying they wanted to reduce their risk. As a result, stocks reached all time lows and bonds became overvalued. However, those individuals who stuck to their financial plans and did not sell their stocks, not only saw their investments regain their losses, but also experienced less volatility and stress.
The dot-com era and the recent financial crisis were not exceptions; we have seen similar emotionally-driven distortions in the market: the rush to gold and real estate. Investor emotions influence investment behavior much more than we realize. Investors need to create a financial plan customized to their individual needs and circumstances. The plan should include an Investment Policy Statement (IPS) which delineates how much should be invested in stocks, bonds, real estate, etc. based on your goals and risk tolerance. The IPS should be updated at least annually or when your circumstances change, not when the market rises and falls. For example, if you determine that you should have 50 percent in stocks and the market rises sharply whereby your stocks now represent 65 percent of your wealth, the appropriate action would be to sell off 15 percent of the stocks to bring you back to the policy plan of 50 percent because that is what you initially decided was an appropriate risk level for you. To use Alen Greenspan’s (Former Chairman of the Federal Reserve) term, lets not let the market’s recent upturn lead us to “irrational exuberance”.
Have a question or need advice on how to manage your retirement accounts? Contact ACap Asset Management at firstname.lastname@example.org or 818-272-8511.
Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Visit us at www.acapam.com