Too many investors become anxious when the stock market is falling and excited when the stock market is rising. Unfortunately that is why the average investor dramatically under performs the broad markets as they sell after prices have fallen and buy after prices have risen.
The key to controlling emotions is to understand that the purpose of your investment portfolio is to serve your personal financial goals. If you want to worry less about short term market gyrations, the solution is to have a sound financial plan with reasonable return assumptions based on current market prices. This means that you use lower return assumptions when prices are high, and higher return assumptions when prices are low.
As an example, when the S&P 500 was recently at 2000, our ten year likely return range was 3.25% to 7.0%. At 1835, the ten year range is 3.75% to 7.75%. Back at the low point for the last bear market in 2009, the ten year return range was 8% to 12%.
For our clients, as stock prices have continued to move higher over the last several years we have adjusted return assumptions down accordingly. If prices were to continue to fall we will raise our forward return assumptions, and if they rise too quickly we will lower forward return assumptions to align with the new price level.
If your financial plan is viable, drops in the market will then have no effect on your long term financial security as long as you don’t let your emotions control your investment decisions – i.e. if you have more money but returns are lower, it is the same as having less money with higher returns. For example if you have $100,000 invested for ten years at 7%, the ending value is equal to having $90,000 invested at 8.25%.
As an additional risk reduction strategy, our portfolio management approach is to decrease exposure to stocks as prices get expensive, and increase exposure as prices get cheap – buy low and sell high. When the last bear market for stocks ended in March of 2009, our strategy was to keep our clients allocated at the top of their stock range. As the U.S. bull market aged and stock prices moved higher, we lowered stock exposure so that by 2013 we recommended keeping stock allocation at the middle of each client’s individualized stock allocation range. We likely would now have stock allocations even lower if foreign stocks were as expensive as US stocks. However, because foreign stocks have much lower valuations than US stocks we have actually been increasing our exposure to foreign stocks.
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