As I’ve gotten older, my risk tolerance has steadily declined. This is why I’ve only got ~30% of my net worth allocated to the public markets. When you accumulate enough wealth, you no longer want to have as much exposure to assets that are intangible, risky, and hard to control. There’s just too much at stake.
For example, let’s say you’ve got a respectable $200,000 invested in the market. If your portfolio loses 30% of its value, you can still make up the $60,000 loss through contributions from your various income sources. It may take a while, but based on current median income levels, $60,000 is not an insurmountable loss.
If you lose 30% on a $2 million portfolio, making up $600,000 is a grind! If the $2 million was derived mostly from middle class wages you earned over the decades, you’ve pretty much screwed yourself out of ever living off a $2 million portfolio if you planned to retire then. You might be dead long before you ever get back to even.
THE HISTORY OF MARKET DECLINES
Some may think: the more money you have, the more risks you can take! In my 20s, I used to think this way. Ah, to be young and so bold. As you get older, you stop thinking only about yourself and begin thinking about taking care of your aging parents, your spouse, your children, and other people around you who are less fortunate. Responsibilities increase with age. They don’t decrease.
During times of volatility, it is always a good idea to reassess your risk tolerance. This latest bull market created “investment gurus” out of many people who’ve never experienced a downturn. Downturns always come. The question is whether you have the risk tolerance to hold on until the recovery?
A correction in the stock market is usually defined as a 10% or greater drop in a major index like the S&P 500. But as we know from history, bear markets sometimes correct much more than 10%. Take a look at the chart below which details previous downturns.
The stock market can easily go down 50%+ over a 5 – 10 year period. If you have to sell during a bear market, you will likely miss out on huge gains later on. A 50% decline in an investment requires a 100% increase just to get back to where you started. What investors need is time in the market to withstand all the punches.
Now that we’ve reviewed the history of the stock market, it’s easy to see how we could correct even further than 10% given sluggish employment, problems in Europe and China, valuations on the upper end of historical ranges, rising interest rates, a bubble in private equity, and slowing corporate profits.
The stock market tends to be a great harbinger of things to come. Once the stock market goes, so goes the property market, labor market, private equity market, and everything else.
FOLLOW THE SLAUGHTER RULE FOR INVESTING
If you are unable to withstand a 50% drop in stock prices, then do not invest in the stock market. Those who are unwilling to lose 50% of their capital will inevitably panic sell and miss a likely rebound.
For those who didn’t have much capital invested during the 2008-2010 crash, it’s more than likely you are overconfident about your risk tolerance. The common response to a 50% correction is, “I’ll just buy more!” and “Stocks are on sale!” These types of responses demonstrate either a lack of memory or the lack of experience during times of difficulty.
If the stock market is crashing by 50%, everything else is also getting crushed. Your job loss risk just increased by 10X. Your entrepreneurial income is getting slaughtered because clients stop spending money. Non-prime real estate will flood the market, sending prices lower. When your world is collapsing around you, all you want to do is hoard as much cash as possible.
If Apple’s earnings are down by 50% and AAPL shares are also down by 50%, Apple is NOT on sale. It’s valued based on price to earnings multiples is still the same. The only time a stock is on sale is when the current valuation overly discounts future profit expectations. Please understand this basic concept.
BE HONEST WITH YOUR RISK TOLERANCE
“Don’t confuse brains with a bull market.” – Humphrey Neill.
Be honest with your risk tolerance by carefully analyzing your net worth makeup to help protect yourself and your dependents. Just because someone has 90%+ of his net worth in the stock market doesn’t mean you should too.
With ~30% of my net worth in the stock market, my net worth would take at least a 15% hit in case of a 50% correction. Unfortunately, if the S&P 500 is cratering by 50%, my real estate holdings and business will probably also burn in hell as well. Having just ~10% of my net worth in CDs and cash just doesn’t feel like enough anymore.
I’m bracing for some lean times ahead and so should you. Over the next 12 months, my plan is to save as much cash as possible, find a full-time job or new consulting opportunities, and look for more online business partnerships.
Recommendation To Build Wealth
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Updated for 2020. After 10+ year bull market, protecting your capital is a wise move.