What goes up must come down. I don’t want to be the jinx that investors may fear, but someday your portfolios will again suffer losses and you’ll be wondering what to do. Now that the sun is shining on many portfolios it is a good time to fully understand what the consequences of significant market drawdown may mean for your life and financial plan.
The first place to start is to truly understand how much risk you are taking in your investment accounts.
The first aspect of risk is just how much your portfolio could decline under a few different scenarios. For investors in risky assets, I suppose it is possible to see your portfolio go to 0, but for most well-diversified portfolios that would have to be one worldwide catastrophic event.
The greater likelihood is a drawdown that is less like Armageddon and more like past bear markets. How would you feel if, as in 2008, your equity portfolio dropped by over 50 percent? Would that be enough to cause you to sell everything and stuff your nest egg in a mattress? Or are you a longer term investor who has experienced drawdowns before and can tolerate that level of discomfort?
It is possible to analyze your specific portfolio and see how it has fared in the past under the full range of prior conditions. Not that the past is any indicator of the future, but it at least allows you to see the historic range and behavior of your investments under varying conditions. From here, you may agree to modify your holdings. You may look to increase your risk if you are looking for greater gains or you may decide to lower the risk because you realize that you can live with lower net returns over your life expectancy.
Next, understand your financial plan.
How much do you need to earn on your entire portfolio to reach all of your life objectives? For many, finding out the answer to this may relieve a lot of stress. Not only will it help you to establish an investment risk policy and set an appropriate allocation – but it will add color and expression to the rest of your life vision. It will help you understand whether you are working because you need to or because you love to. It will help make the right decision about downsizing your home or buying a second one. It will help immensely with family planning such as helping to pay for a grandchild’s college or helping your own children get a financial head start in life.
Also look at the upside of risk. That is, evaluate the upside of your portfolio given the risk level that you are assuming. Today, caution should be given to those investors who are too conservative. The math is simple, if your portfolio’s performance lags the cost of living increases that we all face, you may run the risk of losing enough purchasing power to alter your standard of living.
But remember: there is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification and asset allocation do not protect against market risk.