“The stock market just plunged and I’m scared. What should I do?”
First and foremost, if you have money in the stock market you should clearly understand that it will not always go up, and you should expect downturns for both long and short term time periods. Instead of making rash, reactive decisions to a market decrease, you should anticipate that it’s always a possibility. Have a plan, implement it, monitor it, and stick to it!
How you react to “plunges” in the stock market will vary widely. Some of the top variables affecting your decision making are your overall financial situation, your risk tolerance, your needs, and perhaps most importantly, the stage of your financial life.
Let’s run through some scenarios based on different phases of your financial life and examine how, or if, you should react to financial downturns.
The accumulation phase
This is the phase when you are accumulating assets in order to achieve a goal. You should have a clearly documented goal or goals and have an investment plan surrounding these goals.
This is you:
- Early 30s
- Recently married
- 1 child on the way
- Getting ready to buy a house
- Saving for retirement
You are in your prime earning years.
The down payment for your house should be invested very conservatively in cash or short term bonds. This is a good rule of thumb any time you have a goal requiring use of funds within a year. You do not want to experience a short term market fluctuation and come up short on the down payment. This is an example of making preemptive decisions about market fluctuations. Note that you are not attempting to guess what the market will do, you are making decisions based on your goals. Since you are a savvy 30 year old and your down payment is in cash, you are protected and the stock market decline will not affect the purchase of your home!
Let’s say you have some extra cash and your child’s college education is important to you. You should consider setting up a 529 plan to make monthly contributions and receive a state tax deduction. Your child is 1, so you have 18 years to invest the money and accumulate assets. In this case you should actually be happy about a stock market decline. You should be investing as much as possible. Since you assume the market will go up at some point you are buying stocks at lower prices and should benefit by the short term downturn. Also, since you are investing on a monthly basis, you will hit future ups and downs and average your cost into the market. Investing conservatively until the market feels better will not help you reach your goal.
The market will not be less risky, it will just feel that way since it is going up and you will miss out on the recovery.
You are also saving for retirement in a company 401(K) plan. Since you are young, you should already be invested in a relatively risky portfolio of stocks. Should you sell and move to cash until the market improves? No. You should keep making contributions and buy the stocks at a lower price than before. If you were investing in stocks over the last couple of years while the market was up, you should continue on that track while it is down. Remember, this is a long term goal. You have time to recover, and you need to take risks in order to reach your goal. Being more conservative may actually make it harder to achieve your goal; you will need to save much more.
This is you:
- 58 years old
- 3 kids who are out of college
- Sizable assets saved for retirement
- 5 years until retirement
Should you panic, sell everything, and wait it out? No. This is a really good time to fine tune your plan. You need to analyze your current financial situation and see how close you are to reaching your goals. In order to determine how much risk you should take you need to determine how much you will like to spend.
Let’s say you have accumulated $3,000,000 in assets and you want to spend $100,000 per year. In this case you may have enough assets already and you may not need a lot of investment return over the remaining life of your portfolio. This means you can take less risk. Don’t panic and do it in one shot. You are still working and saving money. You can use your future contributions to buy more fixed income which will start to make your portfolio more conservative over time. When you hit retirement you will be in good shape.
Also, as the market goes up you can slowly rebalance your portfolio by moving gains from stocks to fixed income. If you happen to be very aggressive and you determine you have enough money you can make changes to be more conservative, but you don’t have to panic and sell everything.
If you only have $1,000,000 and you want to spend $100,000 you may not have enough and in order to get where you need to be you may actually need to take more risk. The more risk, the more potential for returns. If you are too conservative, you are limiting your chances of reaching your goals, not increasing them. If taking more risk scares you, then it is time to reevaluate your goals. You may need to work longer or spend less. There are trade offs for everything.
This is you:
- 78 years old
- Retired for 12 years
If you have planned properly and you retired with enough money, your current investment allocation should be relatively conservative. You should only have approximately 50% in equities. Although your portfolio will go up and down you should not be in a position where you will lose everything. You should be diversified internationally and balanced among various asset classes. You need to begin to think about who you are investing for: your current needs or your kids. If you are spending less than you thought and your portfolio has grown over time, you will likely be leaving asset to your children (if any) and they are going to be much younger and have a longer time horizon for the market to recover. This gives you the ability to take a little more risk.
Finally, analyzing your risk tolerance is important. If you are not comfortable and you have enough, step back and have your advisor run some projections and see how much you need to earn to live comfortably. If you have enough and you still cannot sleep at night, then it is ok to be a little more conservative.
The bottom line: your decision to react to the market should be based on a well thought out financial plan, not short term market volatility.
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