Gut Check: Will You Be Prepared If Stocks Plummet?

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By Walter Updegrave, RealDealRetirement @RealDealRetire

Given the stock market’s surge of the past five years, chances are your retirement account balances are at or near a record highs. But while it’s impossible to predict what will trigger a reversal, we all know that at some point the market will take a dive. Will you be prepared when that happens?

Better to make sure now than waiting to find out when a crisis actually hits. The best way to do that: gauge your true tolerance for risk and confirm that your retirement accounts are invested in a way you can live with whether the markets are sizzling or fizzling.

Before I get into the nitty-gritty of how to do that, you should know that there’s a bit of a brouhaha raging in the investment world over the topic of risk tolerance. Some experts contend that investors’ appetite for risk tracks the market—that is, investors are more willing to accept risk when the market’s going up, less so when it’s headed down. They point to the fact that  more money typically flows into stock funds during market upswings, while investors pull more out after the market melts down.

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Michael Finke, a finance professor at Texas Tech University, and Michael Guillemette, an assistant professor at the University of Missouri, lay out the case for this view in a recent study titled “Do Large Swings In Equity Values Change Risk Tolerance?”

Others, such as Geoff Davey, co-founder and director of FinaMetrica, an Australian firm that creates a risk tolerance questionnaire that’s used by financial planners here and abroad, say our sensitivity to risk is generally stable, much like a personality trait. People invest more aggressively during bull markets and more conservatively in bears not because their appetite for risk has grown or shrunk, contends Davey, but because “their perception of risk has changed.”

Basically, this camp says we underestimate the risk we’re talking after stocks have been on a roll and overestimate it after the market has tanked. He notes that the scores on his risk tolerance test remain pretty constant in both up and down markets.

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Fortunately, you don’t have to choose sides in this debate to create a portfolio that reflects your true appetite for risk. In fact, I believe good to keep both perspectives in mind as, clearly, the level of risk you can stomach as well as your sense of how much risk you’re taking at any given time should both be taken into account when evaluating your retirement investing strategy.

So how can you get a handle on your risk tolerance and factor that knowledge into your investing decisions?

A good place to start is by completing a risk tolerance questionnaire. Vanguard has a free Investor Questionnaire you can access through RDR’s Retirement Toolbox. Answer just 11 questions designed to gauge what size loss you feel you could comfortably stand and how long you intend to invest your money, and you’ll get  a recommended blend of stocks and bonds.

Or, if you want a more comprehensive assessment, you can go with FinaMetrica’s a 25-question risk profile questionnaire at www.myrisktolerance.com. It costs $45 and grades you on a scale of 0 to 100. After getting your score, you’ll also receive a detailed report for interpreting the results. If you go the Resources and FAQs tab at the company’s site for advisers, www.riskprofiling.com, you can then download an asset allocation guide that translates that score into an appropriate asset allocation.

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I completed both questionnaires and came away with suggested portfolio allocations that, while not exact, were certainly in the same ballpark.

Next, you want to know how that recommended combo of stocks and bonds might perform in a down market by looking at how it’s done under past periods of stress, and determine whether you would be comfortable with the results.

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Let’s say your risk tolerance assessment suggests a mix of 75% stocks and 25% bonds. Such a mix would have left you with a loss of nearly 40% from the market’s high in 2007 to its low in 2009 . If that kind of setback would have had you bailing out of stocks entirely—and possibly missing the rebound that’s taken the market to new highs—then you may be better off with a more conservative allocation.

Just keep in mind that a less aggressive mix comes with lower returns that could make it more difficult to accumulate the savings you’ll need for a long retirement. If you’re already drawing on your nest egg, going too conservative could mean you won’t be able to draw as much income from savings, or you could run through your savings sooner. So you’ll want to balance your emotional desire for short-term protection from market setbacks with your  need for adequate returns. The T. Rowe Price Retirement Income Calculator in RDR’s Retirement Toolbox can give you a sense of how different mixes of stocks and bonds affect the amount of income you can draw from savings in retirement.

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As you go through this exercise, try to avoid getting lulled into a false sense of security when stock prices are soaring, or getting too cautions after prices have collapsed. Ultimately, you want to end up with a stocks-bonds mix that’s consistent with your true tolerance for risk, and that you can comfortably stick with even when the market heads south.

Finally, you’ll be much better off if you do this sort of evaluation now, while conditions remain relatively calm, than trying to re-jigger your investment portfolio in crisis mode after the markets have gone kerflooey.  (8/11/14)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.

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