Test your portfolio (and yourself)
I often tell clients that one of the most valuable services I provide is preventing them from doing something foolish.
Usually, this means convincing them to stay the course as their portfolio falls in value during market downturns. In our business, we refer to this as “talking someone off the ledge,” a gallows-humor reference to the poor souls who jumped off buildings during the 1929 stock market crash.
One of the techniques I sometimes use is to “stress-test” a client’s portfolio while at the same time having them stress-test themselves. It is not a stock market decline that is the greatest danger to an investor; rather, it is the investor’s ill-advised reaction to a decline that does the most damage.
Stress tests are used in all walks of life to gauge the ability of someone or something to withstand pressure. Your doctor might run you through a stress test to determine the condition of your heart. Engineers stress-test materials to find their breaking points. During the financial crisis of 2008, banks were subjected to stress tests to determine whether they were sufficiently capitalized to withstand the fallout.
As the stock market falls during a correction, the pressure on an investor intensifies, and everyone has a different capacity to handle that pressure.
I always tell clients that if they have only 10% of their money in the stock market but they can’t sleep at night during a downturn, that’s still too much.
The classic investor mistake of selling near the bottom usually occurs because an individual has misjudged how much “pain” they can withstand. The investor cashes out when it becomes unbearable for them to see their portfolio decline in value any longer. Inevitably, they then miss the market rebound.
To help yourself avoid this situation, try this exercise:
1. Imagine what you believe to be a worst-case stock market downturn, and determine the effect it would have on your portfolio.
2. Put it in dollar terms. For example, let’s say your $500,000 portfolio is half stocks and half bonds. The market has been falling, and you think it could potentially go down another 20%. Since only 50% of your money is in stocks, your portfolio would fall another 10% give or take. This doesn’t take into account that your bond holdings may rise in value.
3. Honestly ask yourself whether you could handle that additional $50,000 decline without panicking and pulling money out of the market.
If the answer is yes, relax. In fact, you may get an opportunity to buy additional stock at bargain prices.
If the answer is no, you probably have too much money in the stock market for your individual risk tolerance.
Talk to your advisor. Just a small adjustment to your portfolio could prevent you from making an emotional decision that you’ll regret.
Marc Amateis is vice president at Landaas & Company.
initially posted Dec. 6, 2012
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