Rethinking Your Appetite for Risk

07/15/2008 12:00 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

Editor's Note: Today MoneyShow.com launches the SavageMoney Blog, a brand-new blog from one of the nation's leading experts on personal finance. Terry Savage, an award-winning writer, speaker, and television personality, will give her unique take on critical issues affecting your finances, including retirement, investing, health care, taxes, and estate planning. And you can join the conversation with comments and questions that Terry will answer throughout the week. Visit the SavageMoney Blog every Monday on MoneyShow.com and have your say!

As you start opening your quarterly investment statements in the next few days, it will become apparent that during the second quarter we moved into bear market territory. Sure, the market has rebounded in the past week, but that gives you the opportunity to ask yourself: Can you ride a bear?

The traditional measure of a bear market is a decline of 20% or more. We reached that mark in early July. On October 11th, the Standard & Poor’s 500 index reached an all-time intra-day high of 1576.09. At the end of June 2008, the closing level was 1280—a decline of 18.8%. By July 9th, the S&P 500 was off 21 percent from its peak. Can you hear the growls?

It's been a surprisingly quiet bear market-from a media standpoint. Maybe that's because all the pundits are too preoccupied with truly gruesome statistics such as home foreclosures and personal bankruptcies. But sooner or later, they'll notice. And that's when the headlines could lead to panic selling from those who haven't thought out their investment strategy-or taken a reflective look at their own emotional tolerance.

Statistics say you should be a long-term investor-although there's certainly nothing wrong with taking a portion of your funds for a trading portfolio. But according to Ibbotson Associates, the market historians, there has never been a 20-year period (going back to 1926) when you would have lost money on a diversified portfolio of large company American stocks-with dividends reinvested. And you would have beaten inflation, as well.

That's the argument for creating a diversified portfolio, adding to it on a regular basis (dollar-cost averaging), and sweating it out through bear markets. In fact, if you're a regular at MoneyShow.com, you're probably a reasonably sophisticated investor who knows this stuff by heart. 

But will your finances survive a sharp decline-or a long period of market stagnation? That's a good question to ask, because it takes years to learn the lessons of the market. And if you've come out ahead so far, you might not have that many years to do it again! 

So, it might be time to reassess your risk tolerance in light of your current age and financial situation. As you near retirement, you won't have the luxury of continually making new contributions to your retirement plan. In fact, you're getting closer to the time when you'd like to start making withdrawals. Or maybe you're already taking distributions.

Your risk tolerance might not change from an investment point of view, but your perspective on loss certainly changes as you move closer toward your retirement targets.

For sure, some investors can close their eyes to the emotional drain of a bear market. They have enough money so that a temporary decline won't impact their lifestyle. But think back to the period between 1972 and 1982, when the market remained essentially flat, and below the 800 level on the Dow Jones Industrial Average. If that era happened again-and markets never repeat exactly-could you withstand the drain on your assets?

There's an old Savage Truth in the market: Sell down to the Sleeping Point! Well, don't wait until you're in the midst of a nightmare to decide exactly what level of equity exposure will allow you sweet dreams. This may be a good time to think about it again.

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