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Would you be okay if stocks entered a deep slump with your money invested as it is today? It’s an important question because even though crashes are inevitable, it’s impossible to predict when they’ll arrive. Which means the difference between scrambling in a panic or being confident enough to ride out a meltdown until the market recovers is getting ready ahead of time. Here are three things you can do to be better prepared.
1. Do a quick review of your portfolio. Over the course of a long bull market—the current one is going into its sixth year—it’s easy to pick up all sorts of gimmicky investments that can turn what started out as a well-balanced portfolio into a hodgepodge of holdings that no longer work in concert and may put your wealth at undue risk. Better to go over your holdings one by one now and weed out investments you may have bought on the spur of the moment or that seemed like a good idea at the time but on reflection deserve no place in your portfolio. (Do you really need that triple-leveraged ETF or that fixed indexed annuity?)
A simple-but-effective way to conduct such a review is to ask yourself these questions about each of your holdings: Does this investment play a specific and valid role in your portfolio that still makes sense today? Does it make up an appropriate percentage of your holdings, or has it grown too large (or shrunk) since you bought it? And, most importantly, if you were investing your money today, would you still buy this investment? Keep in mind that selling investments in taxable accounts could trigger taxable gains, although you may be able to offset that gain with realized losses in other investments.
2. Confirm that your portfolio still reflects your tolerance for risk. There are two schools of thought about why many investors take on more risk in the later stages of a long bull market. One is that people’s tolerance for risk changes, expanding in bull markets and contracting during downturns. The other is that risk tolerance remains relatively constant, but investors invest more aggressively because they underestimate the heightened risk they’re taking when stocks are selling at inflated prices.
Whichever is true (and for what it’s worth, I think the second explanation is more plausible), the important thing is to make sure before stocks go into a nosedive that your portfolio and your risk tolerance are in synch. To gauge your tolerance for risk, you can check out Vanguard’s free online risk tolerance-asset allocation questionnaire. You may be able to simply eyeball your portfolio to determine how your holdings divvy up between stocks and bonds. But for a more accurate fix, you can plug the names or ticker symbols of your investments into Morningstar’s Instant X-Ray tool.
3. Make a commitment. Or, more accurately, a commitment device, a technique for making sure you do something you know you should do but you may lack the willpower to carry out in the heat of the moment. One of the most famous examples can be found in Homer’s epic poem The Odyssey, when Odysseus (or Ulysses, his Latin name), has his men bind him to his ship’s mast so he won’t be lured onto the rocks by the seductive song of the Sirens.
So what might serve as a commitment device, or Ulysses contract, for an investor? Well, to ensure you don’t bail out of stocks and rush to cash or gold or whatever when the market is tanking, you might write down why you’ve settled on your current asset allocation and promise in writing that you’ll hold off at least a week before making any changes to your stocks-bonds mix. Combining a reminder of why you’ve invested the way you have with a cooling-off period may be enough to prevent you from making a rash move you’ll later regret. (By the way, this tactic can also help stop you from investing more aggressively than you should when the market is soaring.)
The point, though, is to sketch out a long-term investing strategy that makes sense given your risk tolerance and financial goals, decide coolly and rationally before the market goes into a slump how you ought to react when it does—and then set up a back-up system so you don’t abandon your well-laid plan when stock prices are hitting lows and emotions are running high.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.