If you’re looking how to quantify risk tolerance and how to determine the appropriate exposure to stocks, you’ve come to the right place.

This post is also for someone who is wondering:

• Whether they have the proper asset allocation
• If there is a way to reduce investment stress while still benefitting from returns
• How to quantify their risk tolerance
• How to continue moving forward on their path to financial freedom despite all the uncertainty

One of my primary goals on Financial Samurai is to help readers build meaningful wealth in a risk-appropriate manner. You need to learn how to quantify risk tolerance before making the right amount of investments.

Because I started my career soon after the 1997 Asian Financial Crisis, I’ve experienced a lot of carnage as many international college students in the US had to drop out due to a sudden and massive devaluation of their respective home country’s currencies. I fully appreciate how hazardous the road to building great wealth can be.

Control Your Risk Exposure

Even the best-made plans can be laid to waste due to some unforeseen exogenous variable. We always hope for good surprises along the way. The coronavirus pandemic is certainly one of the biggest unforeseen black swan events in our lifetime.

Unfortunately, life always has a way of kicking us in the face after knocking us in the teeth. Let’s always be thankful for what we have and demonstrate kindness to those who are experiencing difficult times.

Most investors overestimate their risk tolerance, especially investors who’ve only been investing with significant capital since 2009. Once the losses start piling up, it’s not only the melancholy of losing money that starts getting to you, it’s the growing fear that your job might also be at risk.

The Richer You Are, The Harder You May Fall

You might also erroneously think that the richer you get, the higher your risk tolerance. After all, the more money you have, the bigger your buffer. This is a fallacy because the more money you have, the larger your potential loss. For most rational people, their lifestyles don’t inflate commensurately with their wealth. This is why even rich people can’t resist a free rubber chicken lunch.

Further, there will come a time when your investment returns have a larger impact on your net worth than your earnings. As a result, the richer you are, the more dismayed you will be to lose money. Your main hope for recovery is a rebound in investment performance because your work earnings won’t contribute much at all.

Well, we’ve done it, folks! Despite COVID-19 and tens of millions of Americans unemployed, the NASDAQ successfully completed its V-shaped recovery and the S&P 500 isn’t too far behind.

In this post, I want to go through some key lessons from this most extraordinary and largely unexpected rebound. We are firmly back to bull markets, despite the economy still in ruins.

I’m not buying into this rally, but I continue to hold my pre-pandemic stock positions with wonderment and bewilderment.

As always, the goal is for all of us to become better investors in order to achieve financial freedom sooner, rather than later.

Despite not wanting to buy stocks after the S&P 500 has rebounded by over 30% since its March 2020 bottom, I still own a significant amount of stocks across a number of investment portfolios: two 529 plans, a SEP IRA, a Rollover IRA, a Solo 401(k) and a couple taxable investment accounts. Then there’s my wife’s SEP IRA, Rollover IRA, and two taxable investment accounts that own mostly stocks as well.

One would think that if I didn’t want to buy stocks after a rebound, I should also be willing to sell stocks that I already own. I do want to sell and I have sold plenty in my accounts in order to de-risk, but I’ve held off on selling stocks in most of my tax-advantageous accounts due to a variety of reasons I’ll talk about in this post.

To be clear, I’m not advocating buying after a huge rebound. I’m going to explain in 12 reasons why I haven’t gone to 100% cash or short-term Treasury bonds across all my portfolios. Everybody is at a different stage in their financial journey. Nobody knows for certain what the stock market will do, so please keep an open mind when reading. This post should help explain why so many people keep buying, despite all the destruction.

Starting on May 1, 2020, my main focus has been to get as smart and as financially prepared about real estate as possible.

In May, I have:

• Gotten preapproved for a mortgage to give myself more firepower to take advantage of any deals.

• Analyzed all the closing costs for buying a home with cash and with using a mortgage so I can make a truer offer.

• Gone through the process of understanding whether using a real estate attorney is worth it or not to cover my bases.

I believe the easy money in stocks has already been made after a 25%+ rebound. Therefore, I’ve moved on to focusing on new opportunities in real estate. I’m always trying to think ahead, not behind.

After publishing my real estate attorney post, I got this comment from a reader:

Hi Sam,

I really like your blog and appreciate your clear thinking, concise writing, and wealth of knowledge. However, I’m a bit disappointed that since March 18 you haven‘t been covering the stock market and I am missing your help on interpreting the irrational developments there.

The question of “Do I need a real estate attorney?” pales in comparison to “How on earth can the stock market rally in face of the greatest recession since 1929?” I would really appreciate your wisdom here.

Thanks Sam!

– Tom

My first thought was how selfish I was to write mostly about real estate in May. Given I own Financial Samurai, I should write more about what other people want, not only about what I want.

My second thought was how I failed to properly communicate my thoughts on the stock market during this time of crisis. After publishing How To Predict A Stock Market Bottom Like Nostradamus on March 18, Tom thinks I’ve been radio silent.

A good teacher is only as good as the student who needs the most help in his or her classroom. I believe in leaving no one behind during this time period. Therefore, I have let down Tom and others who feel the same way.

To make things right, let me share my crystal clear thoughts on the stock market after a huge rebound.

The yield curve inverted in 2019 and the recession is now here in 2020. Although stocks have rebounded aggressively since its March 2020 low, the economy is still in a precarious state. Due to investor psychology, the S&P 500 generally goes up like an escalator and goes down like an elevator. Let’s look at the average daily percent move of the stock market.

If we’re long-term investors, it’s a good idea to understand how much the stock market moves a day on average. When stock market volatility spikes, we’ll feel more calm and reduce our chances of doing something irrational.

The Average Daily Percent Move In The Stock Market

Below is a fantastic chart that shows the daily percentage movement of the S&P 500 over the last 10 years. Each dot represents one day.

As you can tell from the chart, the average daily move in the stock market is between -1% and +1%. The S&P 500 represents the stock market.

Therefore, if you are a long-term investor in the capital accumulation phase, you should consider buying more than your normal investing cadence when the S&P 500 is down greater than 1%.

If you’re in capital preservation mode, you might consider selling some of your S&P 500 index position when the S&P 500 is up greater than 1%.

Of course, nobody knows the future. Trying to beat the S&P 500 over the long run through market timing is unlikely to work.

However, we’re not trying to outperform the S&P 500. What we’re trying to do is figure out how to best invest our cash flow, or larger-than-normal cash injections, during the capital accumulation phase and vice versa.

Here’s another historical average daily percent change chart for good measure.

If you’re wondering about active versus passive investing performance, you’ve come to the right place. Overall, it’s better to be a passive investor because it is very hard to outperform various stock market indices.

One of the reasons why I left institutional equities in 2012 was because I felt it was a dying business. Trading commissions were getting squeezed due to algorithmic trading and other technological advancements. Further, assets under management (AUM) for active money managers was also declining due to poor performance.

Working harder and getting paid less was already demoralizing. Watching my clients I cared about work harder and underperform their respective indices made me feel like my job was pointless. When you feel like your job is pointless, it’s time to do something new.

Since the time I left my day job, the business has only gotten worse for actively managed funds. Yes, it is true that passive money managers gained a tremendous amount of assets during this time period.

But there is no excitement speaking to an index fund manager or analyst because they don’t do any analysis. All they do is follow the moves of their benchmark indices. For example, if the S&P 500 removes one name from its index, so does the index fund manager.

As of 2020, the market share of passively managed equity funds has risen to 45 percent according to Bank Of America. For passively managed bond funds, the market share is roughly 25 percent. The market share gains will likely continue.

Let’s look at some active versus passive investing performance in equities and fixed income over the past 10 years. You’ll be shocked at the results.