The Dow and S&P 500 have now both broken below their 50-day moving averages, down over 4% from last week’s 52-week highs. After five down days, many of the popular momentum indicators are trending lower. So if you’re following this, what to do now?
You can see, surely, the problem with market timing. There really is no answer to the timing question. Do you sell some now, locking in some profits before further price drops? Or do you buy some now in this dip, ahead of a new up-trend? Maybe some of both, in different sectors? How high or how low will the market go? When?
Of course, no one knows the answers to those questions. Hope is not an investment strategy, as they say. So what to do?
Backing up, why invest? Because you need to have money set aside for those times when your spending exceeds current income or you are no longer working. And because idle money loses value to time and inflation, and so should be safely invested to grow over time.
So the question isn’t so much when (timing) as it is what to invest in—how to allocate your savings. Ibbotson and others have shown that 90% of investment gains are the result of how your funds are allocated across different classes of investments, and only 10% is due to security choice (stock picking) and timing. It’s not that the 10% doesn’t count—it’s that you have far more to lose if you get the 90% wrong then you have to gain by picking and timing stocks. And the 90% is the only part of the equation you control.
If you’re into stock picking and timing, you’re probably trying to divine the future earnings of specific companies and the potential returns of their security issues. Guessing how corporate performance and the tug of war over the economy is going to work out.
But if you’re focused on investing across classes of securities for long-term gain—that is, strategic allocation—your focus changes from guessing corporate futures to managing your own investment risk. Unlike corporate futures and the lurch of the economy, managing your own risk is something you can—and should—control.
You may be familiar with those short five or six question ‘risk tolerance’ quizzes your bank or stock broker asks you when you open an account. The compliance department of the broker’s firm requires the questionnaire to show that the financial advisor has determined your tolerance for risk and is therefore recommending ‘suitable’ investments to you as the law requires.
You should be careful about this process—using six or even twenty questions to determine your ‘risk tolerance’ and then overlaying this on a specific investment recommendation is barely more sensible than picking stocks or mutual funds based on last quarter’s earnings or returns or the color of a corporate logo.
Determining the risk you can afford in your investment strategy is a more personal and complex process than taking a ten-question risk profile test. It starts with your personal balance sheet, which includes not just current savings and liabilities but your potential earnings, savings, and expenses.
You need to consider all the factors in your life that affect your finances. Is your job secure? Has your employer cut your salary, and begun or postponed making you whole? Is the industry in which you work growing or in distress? Is your home secure, or are you struggling with your mortgage or other debt? How is your health? Do you have good health insurance? Are you saving for college tuition or have your kids graduated? Do they have jobs or have they moved back in? Do you have a reliable car, or cars, or do you need to lease or buy a later model or new one soon? What major expenses are around the corner? How well prepared are you for emergencies? What income streams will be available to you in retirement—Social Security, pensions, possible inheritances? What kinds of good and bad experiences have you had investing already? What have you learned about investing that will help you do better now?
All of these things and more determine how much risk you can afford to take with your investments. Not surprisingly, the more resources you have and the more you are able to meet your day-to-day and anticipated future expenses, the more comfortably you can invest in risk assets like stocks.
That sinking feeling you feel when the market dips suggests that even if you haven’t done the math—and you should—that you might be in over your head. You might be very risk tolerant in many ways, but you may still be taking more risk than you can afford.
Next time, some general ideas for prudently investing during various stages of your life.