The second key is that in order to deal with the many crises, and the bear markets that accompany them, you have to make sure that you don’t take more risk than you have the ability, willingness, and need to take . As you’ll see, finding this sweet spot is more art than science.
The willingness to take risk
The first step in understanding your willingness to take risk is to take what I refer to as the “stomach acid” test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough? When the only light at the end of the bear market tunnel seems to be the proverbial truck coming the other way, will you be able to avoid panicked selling? Will you be able to focus instead on rebalancing your portfolio back to its targeted asset allocation? That will require you to buy stocks (which have been crashing) and sell bonds (which likely have been rising in value).
As Warren Buffett once noted, successful investment management depends to a large degree on your ability to withstand periods of stress, and overcome the severe emotional hurdles investors face during bear markets. It's best, then, to assess your maximum tolerable loss along with your maximum equity exposure, and then set your investing plan accordingly. And while your plan shouldn’t be based on the worst possible outcome, you should also have contingency plans that can be adopted should losses become excessive.
It’s been my experience that most investors and advisers employ a tool like this one in strategizing and deciding on an investment plan. And while it’s a useful tool, there are several issues we need to address to make sure you find the right answer.
Avoid being too overconfident
The first has to do with the fact that far too many investors are subject to the all-too-human trait of overconfidence. It doesn’t matter what the question is, when asked if we are better than average, about 80-90 percent of people believe they are better than average. While that likely won’t hurt you if you believe that you’re a better than average driver, it can cause you to take more risk than your stomach can actually handle when it comes to investing. The result will be that when crises occur, your stomach will take over from the head and start making decisions. And stomachs rarely make good decisions. Thus, it’s critical that you don’t overestimate your ability to absorb panic that bear markets create in all of us. Don’t lie to yourself (or your adviser), as you’re the one who will have to live with the consequences. To help get this right, think about how you felt during the most recent crises we faced, including not just the bear market of 2008-09, but the European crisis of 2011, and the recent budget and debt ceiling debates.
Pass the sleep well test
The second issue is that you not only have to pass the “will not panic and commit portfolio suicide by selling during a bear market” test, you also have to have a clear enough head to rebalance by purchasing more equities just when the world looks darkest. And beyond that -- you should also be able to pass the “sleep well” test. In other words, if you would be tempted to panic and sell whenever a 30 percent loss in your portfolio occurred, and would start to lose sleep, then it’s the sleep well level that should drive your decision. Life’s just too short to not enjoy it.
Consider how the question’s framed
The third issue relates to a framing problem. Behavioral studies have found that how a question is framed can greatly influence your answer. Rationally, since the questions are really the same, the answers should be the same. Yet, we find that how a question is framed can change the outcomes considerably. Consider the following example for Jaswon Zweig’s book “Your Money & Your Brain”:
One group of people was told that ground beef was “75 percent lean.” Another was told that the same meat was “25 percent fat.” The group that heard about fat estimated that the meat would be 31 percent lower in quality and taste 22 percent worse than the lean group predicted.It's my experience that how the risk tolerance question is framed has a great impact on the answer. To illustrate the point, let’s assume you have a million dollar portfolio. Based on your answers to the “I won’t panic”, “I will rebalance”, and “I will sleep well” tests, let's assume that the maximum loss you want to face is 25 percent. That translates into a maximum equity allocation of 60 percent. However, if you frame the problem in a different way, it’s likely you’ll get a different answer. The right way to frame the problem isn’t with the use of percentages, but with dollar amounts. With that in mind, now consider the answer from the following perspective.
Assume you begin
with a portfolio that is $600,000 in stocks and $400,000 in bonds. Now assume
the stock market loses 50 percent and bonds have increased 12.5 percent. Thus,
the portfolio is now at $750,000, with $300,000 (40 percent) in stocks and
$450,000 (60 percent) in bonds. That's a loss of $250,000. And now it’s time to rebalance. To restore your
portfolio to your target of 60 percent stocks/40 percent bonds you’re going to
have to buy $150,000 of stocks (that have just lost 50 percent and some guru is
forecasting it will drop another 50 percent) and sell $150,000 of your safe
bonds that actually have risen in value. Will you actually be able to do it? Ask yourself. My experience is that investors become more conservative when asked
the question in actual dollars versus percentages.
Ability and need for risk
Determining your risk tolerance requires a great
deal of planning and understanding. As Napoleon said: “Most
battles are won or lost [in the preparation stage] long before the first shot
is fired.” Avoid your Waterloo; decide your ability, willingness and need to
take risk long before your portfolio’s first trade is made.