A time to EVALUATE your jitters


This is a guest post from Bogleheads® forum member Nisiprius, originally published August 7, 2011.  Its central message is always relevant. See this Bogleheads Forum topic for comments.

I want to say this carefully. This is not an optimistic “stay the course”  article and it’s not a pessimistic “OMG do something” article. It’s directed at people who are feeling very uncomfortable. I want to point out some things to think about, things that are hopefully truisms that everyone can see are correct once they’re pointed out.

Your investment plan needs to be in tune with your own personal willingness to take financial risk. Your tolerance for financial risk is what it is. Only you know what it is. Nobody else can tell you what it should be. Different people are really and truly different. And your tolerance for financial risk is not necessarily the same as your tolerance for other kinds of risk.

You may not know what stock market risk is really like, and you may not know what your own risk tolerance really is. This is, if nothing else, a good opportunity to assess both. What we have today is about a 10-15% decline in the S&P over the last month or so, coupled with a feeling of seismic shifts in the financial world. A sense that the earth is moving under our feet. A sense that events are happening that are going to make it into the history books.

Mohamed El-Erian

The general mood is summarized in this El-Erian: downgrade heralds new era

Heralds new era! Strong stuff. Let’s not argue about whether it’s true or not, let’s agree that it feels that way right now. Like there’s been a turning point, a division between an old era and a new era, and therefore past history is no longer a guide to the future. And here’s my point:it always feels that way. That’s always what a big downturn feels like. It’s not a number, 10% or 15%. It’s a sense that there’s been a break, the ground has shifted, the rules have changed.

We love drama and after the fact the reality often turns out to be boring. Imagine thinking that, see, it wasn’t so bad! But that’s later. And sometimes it is a turning point and sometimes it is that bad.

When you’re deciding what your risk tolerance is, it’s not a tolerance for the number 10 or the number 15 or the number 25. It’s not a tolerance for an “A” turning into a “+”. It’s a tolerance for accepting genuinely-scary, nothing-like-this-has-ever-happened-before, heralds-a-new-era news events.

Now, the next set of truisms. Nobody knows what’s going to happen. No, really. I don’t care what the best experts are saying or what the futures do or what happens tonight in Asia. On Monday, stocks might shoot right back up. Or they might plunge some more. Or they might diddle around for weeks leaving us all on tenterhooks and then plunge some more, Or not.
We see this:

Well, we really don’t know what will happen. It might be almost nothing… it might be like the start of this period in 1998 and it could bounce back in a few months.

It might be the start of another 50% plunge like 2008-2009. Awful, but over in a couple of years.

It might be like the start of this period in 1937 when stocks plunged about 50% as in 2008-9, but didn’t come back for about a decade. (I’m using a long-lived stock market mutual fund as a proxy for “the market,” but it’s close enough).

It might be like Japan in 1990, down for two decades and still down.

But not to overweight the pessimism, let me add one more chart. Where’s last week’s plunge? When I expand the scale, it’s actually there. The data being plotted includes it. But apparently it’s so tiny it just gets rounded off or vanishes at screen pixel resolution!

The point is, the last few weeks were a time when some risk showed up, and your job is to process it. The temptation is to deal with the discomfort by choosing a prediction. Don’t. Your job is to confront the reality of that uncertainty, that you do not know what will happen, and can only make the roughest guesses as to the likelihood of all these scenarios. Hopefully, you can say “well, yeah, I knew all that. I’d much rather see the market go up and I feel anxious, but I’m able to stay the course.”

Unfortunately, if you look at all this and conclude that your exposure to the stock market is higher than your risk tolerance, there aren’t any good options. It is absolutely a personal decision. The only sure way to reduce stock market risk substantially is to cut back on your stock allocation. Diversification, fiddling around with different flavors of stock, it’s all bandaids. When stocks plunge, they plunge. So the S&P drops 50% and your portfolio drops 46%, big deal.

And when the stock market is falling, you can’t cut back on your stock market risk without locking in a loss. It’s a tough one and a personal decision. You absolutely have to measure one against the other. It’s crazy to even suggest a course of action to anyone else and I’m not going to try.

What I’m saying is that this is a good time for evaluation. The risk is here. Don’t exaggerate it–we all love drama, but reality is usually more boring than we expect. Don’t brush it aside, look it in the eye as carefully as you can. And then look at how you really feel about it–not how you’d like to feel or how you think you’re supposed to feel.

And one final thought. If we’re lucky, and the stock market comes back at least part way and seems to stabilize for a while… or if it comes roaring back and soars (yes, that’ could happen, too)… don’t forget how you feel right now. If you feel that you are close to the edge of your risk tolerance right now, then you have too much in stocks. If you manage to tough it out and we get a calm spell, don’t forget how you feel now and at least consider making an adjustment then.

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