How to deal with market stress
Dealing with market stress isn’t easy. It is hard to keep cool when the world is going crazy and the markets are crashing. But learning to deal with market stress is a vital skill. Warren Buffett said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble.” That includes the urge to bail out when the market gets tough.
A wise man once said that those who are prepared need not fear. This is a sound philosophy for all aspects of life, including investing. We know that market volatility is a fact of life, so we need to prepare for it. If your portfolio is designed to be resilient in the face of market volatility, you don’t need to fear market a downturn. In fact, if you prepare for it properly, you can use it to your advantage. You can prepare your portfolio for market volatility in three ways.
First, stick with high quality investments. There is a lot of junk out there, so be selective. We can learn a hard lesson from the late 1990s dot-com craze. At that time, a lot of people made a lot of money flipping speculative internet stocks. However, when the market crashed in 2000-2001, most of those companies evaporated and the speculators lost a lot of money. Instead of chasing hot stock tips, invest in stocks that are proven performers.
Second, make sure your portfolio is properly diversified. Bad things can happen to good companies in times of economic stress, so make sure you don’t have too much invested in any one company or sector. If you are holding individual stocks, a properly diversified portfolio will have at least 35 different issues with no more than 4 percent in any given name and 15 percent in any given sector. An even better way to get diversification is to use index funds. Index funds provide very broad diversification at a very low cost.
Third, match your portfolio’s asset allocation to your investment horizon. If you know you will need to withdraw money from your portfolio in the coming five years, invest those expected withdrawals in stable, high-quality fixed income funds. When the market meltdown comes, you will be able to rest easy knowing you can patiently wait for the market’s recovery. On the other hand, if you know you won’t need to draw from your portfolio in the next five years, you can relax with market volatility since market swings usually even out within five years.
Financial planning is the best way to match your asset allocation to your investment horizon. At a very simple level, your financial plan projects your expected income and expenses for each year of your planning horizon. If your projected income is greater than your expenses in any given year, the excess is put into savings and invested. If your income is less than your expenses, the shortfall is withdrawn from your investments. By running projections several years into the future, you will be able to see how much you will need from your portfolio year-by-year in the future. This knowledge will help you better design your portfolio’s asset allocation.
Finally, you can prepare for market volatility by investing a little extra in cash or bonds when the stock market is doing well. It is tempting to run fully invested when the market is strong. However, since you know a downturn will eventually come (it always does and usually comes without warning), the small amount of extra cash or bonds will give you some dry powder to take advantage of low stock prices when the market drops.
I have found that a structured framework for investing helps alleviate the emotional urges that get investors into trouble. Knowing your portfolio is prepared for volatility and that your investment strategy is backed by a well-defined financial plan will give you the confidence you need to endure stressful markets.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.