Investor Psychology

What to Do Now If You’re Losing Sleep Over the Stock Market

Do you fear a bear market? Here’s how to handle your portfolio when ‘staying the course’ isn't enough.

Congratulations! If you’re reading this, it means you’re alive and that the stock market volatility over the past month hasn’t put you in an early grave. Or at least it hasn’t yet.

Let’s call it a victory. Frankly, we should take what we can get. The U.S. stock markets just finished their worst week since the 2008 meltdown and are on track for their worst December since 1931, when America was in the pits of the Great Depression. The Nasdaq is already in a bear market, having dropped a little more than 20%, and the Standard & Poor’s 500-stock index is just 2 percentage points away from joining it.

A 20% drop is psychologically jarring. But a little perspective is needed here. As of Friday’s close, the S&P 500 has been knocked back down to May 2017 levels. If you’ve been invested for any length of time, losing 19 months of gains isn’t catastrophic. It isn’t fun, of course. But it also isn’t likely to make the difference between retiring in style and subsisting on beans and rice in your golden years.

The question is what do you do now?

Whenever the market hits a rough patch like this, there are generally two responses from the financial press. The more respectable voices urge you to tune out the noise, avoid panicking and stay the course. The less respectable voices will urge you to liquidate your stock portfolio; buy gold, canned goods and shotgun shells; and retreat to a bunker in Idaho to await the end of days. Figuratively speaking (mostly).

As a very general rule, the optimists are usually right. Most corrections and bear markets are over quickly, and it often makes sense to sit on your hands and ride it out. By the time you start to panic, the worst has already passed.

But there are times when that would be terrible advice.

There has yet to be a case where shotgun shells, canned good and Idaho bunkers were the right investments, but we have experienced several long stretches of time where buying and holding stocks was a losing proposition. Had you bought at the top in 2000, you wouldn’t have seen a return on your investment until 2013. Stocks also went nowhere between 1968 and 1982, and it took more than 25 years for investors to recover from the 1929 crash. In each of these cases, investors would have done well by cutting their losses and dumping their stocks after the first 20% drop.

So, what’s the right answer here? Do you ride it out, or do you cut your losses now and live to invest another day?

That’s going to depend on your situation. But here are a few pointers to help you keep perspective and decide:

Sell to the Sleeping Point

If stock market volatility is causing you anxiety – if you’re literally having trouble sleeping at night – you probably have too much of your nest egg in stocks. There is an old trader’s adage to always “sell to the sleeping point,” and the same logic applies to rank-and-file investors. Particularly to those in or near retirement.

If a bear market would legitimately put your retirement at risk, you’re no longer investing. You’re gambling.

There’s nothing inherently wrong with gambling – if it’s done for entertainment purposes and with a modest outlay of capital. We all dream of buying a lottery ticket for a dollar and walking away multimillionaires.

But when it’s your livelihood at stake, that’s a very different story.

While shares of stocks may be little pieces of business ownership, owning stock is not the same thing as being a business owner. That’s because you’re a passive investor with no control over how the company is run. Apart from any dividend the stock pays – which is generally modest – the only way to profit is to sell to another investor at a higher price, and there’s no guarantee you’ll be able to do that on the timeframe you want.

So, again, consider reducing your exposure to stocks to a point that it no longer causes you anxiety. If you’re 30 years old and your nest egg is still very modest, you likely won’t lose sleep even if you’re 100% invested in stocks. If you’re 65 and staring retirement in the face, that number presumably will be much lower.

Give Your Asset Allocation a Look

Most investors put at least a little thought into their asset allocation during pivotal moments, such as starting a new job or a new 401(k) plan. But few people remember to regularly rebalance, and that can cause them to take more risk than they realize they’re taking.

As you age and get closer to retirement, you should gradually shift out of stocks and into less-risky investments such as bonds. But often, the exact opposite happens. After a long bull market, the percentage of your portfolio allocated to stocks likely has become larger rather than smaller. That means you’re potentially taking more risk at precisely the time you should be taking less.

There is no “correct” allocation to stocks. But the standard rule of thumb is that the percentage of your portfolio invested in the market should be roughly 100 minus your age – or in more recent models that take into account longer life expectancies, 110 or 120 minus your age. So, if you’re 65 years old, you should have something in the ballpark of 35% (100-65) to 55% (120-65) of your portfolio allocated to stocks. The rest should be allocated to bonds or cash.

These are just rules of thumb, of course. But if your have a lot more than that guideline invested in the stock market, you really might want to consider rebalancing. Yes, you’re potentially selling stocks that have already declined in value, thus crystalizing losses. But again, you’re really only giving up the last 19 months’ worth of gains. That’s a tolerable loss.

Consider Opportunity Cost

As discussed ad nauseam in the financial press and in mutual fund literature, stocks “always” rise over the long-term.

This may very well continue to be true. But you also should remember that you have limited amounts of capital, and your cash might be better invested elsewhere.

Stocks are not the only game in town.

Even after the recent selloff, the S&P 500 still trades at a cyclically adjusted price-to-earnings ratio (“CAPE,” which measures the average of 10 years’ worth of earnings) of 27, meaning that this is still one of the most expensive markets in history. (Other metrics, such as the price-to-sales ratio, tell a similar story.)

This doesn’t mean that we “have” to have a major bear market, and stock returns may be soundly positive in the coming years. But it’s not realistic to expect the returns over the next five to 10 years to be anywhere near as high as the returns of the previous five to 10 years, if we’re starting from today’s valuations. History suggests they’ll be flattish at best.

It’s not hard to find five-year CDs these days that pay 3.5% or better. That’s not a home run by any stretch, but it is well above the rate of inflation and it’s FDIC-insured against loss.

High-quality corporate and municipal bonds also sport healthy yields these days.

And beyond traditional stocks, bonds and CDs, you should consider diversifying your portfolio with alternative investments or strategies. Options strategies or commodities futures strategies might make sense for you. Or if you want to get really fancy, perhaps factored accounts receivable, life settlements or other alternative fixed-income strategies have a place in your portfolio. The possibilities are limitless.

Obviously, alternatives have risks of their own, and in fact might be riskier than mainstream investments like stocks or mutual funds. So you should always be prudent and never invest too much of your net worth into any single alternative strategy.

Just keep in mind that “investing” doesn’t have to mean “stocks.” And if you see solid opportunities outside of the market, don’t be afraid to pursue them.

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