An Ounce of Prevention is Worth a Pound of Cure
While it is too late to change what we did before this episode, it is helpful to think through what prudence looks like in investing. Right now, in the middle of the downturn, it is good to reflect on what your risk tolerance actually is. Here is the next section in my chapter on preparing for a pull back.
One of the best ways to prepare for a downturn is to make sure your risk tolerance and your actual portfolio are in sync. Before 2008 I would ask people a hypothetical question about how they would feel subjectively if they lost 30-40% of their portfolio in a single year. When I used to ask this question, I was pretty sure that this would never happen in my lifetime; then 2008 happened. I found out from clients that they weren’t quite as risk tolerant as they thought they were. I believe it was Ronald Reagan who said that “...a recession is when your neighbor loses his job and a depression is when you lose your job!” In 2008, everyone invested in the market felt the fallout of losing significant portions of their assets. You need to be comfortable with the risk profile of your portfolio to be able to weather the financial storms that come. Another famous quote from my grandfather is that “if you bet the bank, you can lose the bank.” The possibility of significant loss is real in the market so this should temper your exuberance in the good times. If you are nearing retirement and you have 80-90% of your money in the market you really ought to reconsider the overall risk profile of your portfolio. Holding a portfolio like that so close to the end of your saving phase can make you poor to tote it! Having this mentality is very difficult because it goes against our nature. When things are going well we want to double down. As the equity portion of our portfolio goes up we can get caught up in the irrational euphoria of a bull market and think it will go up forever. Instead of getting caught up in the euphoria, during a bull run you should be sober; trim some gains and bank some earnings. As Warren Buffet has said, we should be “Fearful when others are greedy and greedy when others are fearful.”
The way to reduce the risk of your portfolio is to increase the allocation to bonds. As already mentioned, everyone should have some of your investments in bonds or fixed income, and some of your portfolio in equities. Be sure to understand the possible valuation swings of your portfolio with a significant pull back in the market, like we are experiencing now.
Jonathan Baird CFP®