Is your risk tolerance too high? This is a very important question for anyone investing in the stock market. Risk tolerance tells you how much market volatility you can stand before the stress affects your life. Some investors can handle a 30% drop in their net worth without losing sleep. However, many investors will panic sell and lose money when the stock market crash.
Recently, I’ve been questioning my risk tolerance level. I haven’t looked at my risk tolerance in a couple of years and things change. I’m a bit older and I might not be able to stomach another big drop in our portfolio. The stock market has been on an extended run for many years now so a crash probably will come sooner rather than later. For me, that means in the next few years rather than in a decade. Life changes so we need to make sure to update our investment style accordingly.
I’m happy with our asset allocation, but I might need to be a bit more conservative at this point. Let’s review my investment history through previous crashes and see how life changed since 1996. After that, we’ll see if our asset allocation matches my risk tolerance.
The Dot Com Bubble
I started investing in my 401k in 1996, right after I started my engineering career. It took me a few years to max out my 401k contribution and then started investing in a taxable account. The dot com bubble was in full swing by then and many engineers became paper millionaires from stock options and grants. I was still young so I didn’t have much invested at that point, probably around $100,000 when the dot com bubble popped.
The drop in value was very scary because I’ve been investing only for a few years. The big mistake I made was to invest my 401k in my employer’s stock. As you can see from the chart below, the stock dropped quite a bit in 2000 and went side way ever since.
Luckily, I didn’t panic sell like many investors. At the time, my job was relatively secure so I could afford to hold on to my stock investments. I stopped investing in my employer’s stock and gradually moved my 401k to index funds. During the next few years, I kept contributing to my 401k, but didn’t really add much to my taxable account. We put extra money toward our mortgage instead of investing in the stock market. I married Mrs. RB40 in 1999 and we purchased a house soon after.
The 2 most important lessons I learned during the dot com crash were.
- Don’t invest in employer’s stock. My employer already gave me stock options, stock grants, stock discount plan, a job, health insurance, and other benefits. It was a huge mistake to put my 401k in the same stock. That’s too much concentration.
- Keep investing after the stock market crashed. I kept contributing to my 401k and eventually it recovered and surpassed the previous high. Some of my friends stopped investing in the stock market and they didn’t benefit from the recovery. If I could do it over again, I’d invest more instead of paying extra on the mortgage.
The Global Financial Crisis
The global financial crisis was a huge crash, but I didn’t stress out much. I went through the dot com bubble and I assumed the stock market would recover at some point. In 2007, both of us had secure jobs and we could easily weather the downturn. With that assumption, we doubled down on the stock market. We kept investing in our 401k, Roth IRA, and taxable account. Our net worth dropped 25% in 10 months, but we kept shoving every extra dollar we had into the stock market.
Our finance wasn’t perfect, though. The big mistake was purchasing our condo at the height of the housing bubble. The value of our condo is just getting back to that level after 10 years. It would have been much cheaper to buy after the housing bubble popped. There were short sales and foreclosures everywhere. Actually, we did purchase 2 investment properties when the value was reasonable. I figured we’d average down and it is working out well. We should make a nifty profit when we sell those properties.
Important lesson learned
- Buy when there’s blood is in the street. The financial crisis crash was bad, but my experience from the dot com crash told me to keep investing. Buying properties after the housing crash was a good move too. This strategy worked and our net worth increased dramatically over the last 10 years.
- Good steady income gave me the confidence to weather the volatility. I did not lose any sleep during the global financial crisis. Our jobs were secure so we felt safe.
- I wished we had more money to invest during the financial crisis. Our asset allocation was 100% stocks during this period. It would have been better if we had some bond and cash, though. The investment portfolio wouldn’t have dropped as much and we’d be able to buy more stocks during the downturn.
The Next Crash…
Our situation changed quite a bit since 2007. I don’t have a steady income I could depend on since I retired from engineering 5 years ago. My online income is good, but I’m positive it will crater when the next market crisis strikes. Mrs. RB40 still has a solid paycheck so we could depend on that. However, she plans to retire by 2020. That’s why I’m hoping the market crashes soon. We’d be able to weather the storm much better while Mrs. RB40 has a steady income.
Now that I’m older and a bit more conservative, my risk tolerance is a little lower. Our asset allocation is now 70% equity, 10% alternatives, and 20% bond/cash (not including our investment properties.) I still have faith in the stock market, but I want to have some dry powder for the next crash. Our portfolio would drop, but we could convert some bond to stock and benefit from the recovery.
Preparing for the next storm
That might not be enough, though. I’m getting more nervous as the market marches higher every month. That tells me that my risk tolerance is probably too high. What can I do to help me sleep better?
- Reassess my risk tolerance. I went through Vanguard’s investor questionnaire and they recommend 70% stocks and 30% bonds. It’s probably a good idea to increase our bond & cash allocation to 30% because I’m getting more nervous about the stock market. I’ll make this one of my financial goal next year.
- Cut back on individual stocks. I still have complete faith in the stock market and the Vanguard index funds. The US stock market always recovers after a crash and I don’t see why the next one would be different. However, I don’t have the same confidence with individual stocks. Some companies won’t be able to come back. The world is changing and even solid companies could go bankrupt or just stagnate. I think it’s a good idea to sell some individual stocks in our dividend portfolio and put the money in a good dividend growth fund.
Is your risk tolerance too high?
Have you taken a close look at your risk tolerance lately? If it’s been a while, your risk tolerance might be a little high. Your asset allocation and investing strategy are derived from risk tolerance so it is important get it right. Here are some reasons why risk tolerance can change.
- Age – I don’t know about you, but I’m getting more conservative as I get older. When you’re young, you have a lot of time to recover from a loss. At 43, I don’t want to stumble too hard.
- Income stability – Our income isn’t stable anymore. Currently, we can support our lifestyle without drawing down our investment portfolio, but that may change after Mrs. RB40 retires. We need some buffer in the form of cash and bonds so we don’t have to sell stocks at the worse time.
- Investing experience – I’ve been through two big market crashes and came out better. This gives me the confidence to avoid panic selling. We’ll only sell if we need the money.
- Investing horizon – We probably need to sell some investment to help fund our kid’s college education, but he is only six years old. There is plenty of time to recover from market volatility. Once our kid is in high school, then we’d need to be more conservative with that investment.
I suspect many investors think they have high risk tolerance after such a long bull market. It’s easy to keep investing when the stock market is going up, but can you do it when the market is crashing? You won’t know how you’ll react unless you’ve been through a few bear markets.
Lastly, risk tolerance really shouldn’t change much from year to year unless there is a big life event. Retirement, for example, can lower your risk tolerance because of the need to draw down. It’s a red flag if your risk tolerance changes a lot from year to year.
If you have a few minutes, try Vanguard’s investor questionnaire and see what they recommend. Does Vanguard’s recommendation match your asset allocation?
When was the last time you took a careful look at your risk tolerance? Can you keep investing through a crash and subsequent bear market?
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Image credit: Kelly Leeves