Survive the bear market
Now is the time to assess your true risk tolerance and devise an investment strategy that works in the bad - and good - times.
NEW YORK (CNNMoney.com) -- It is gut check time!
This is when we find our true risk tolerance: How much pain can we handle as our stocks and mutual funds tumble?
The bear market hammers us nearly every day with brutal reminders that stocks can be volatile, and so we may be realizing that we overestimated our risk tolerance and put too much of our assets into the stock market.
Risk tolerance, of course, is fundamental to investing money. Those of us with little stomach for the fluctuations of the financial markets, whose primary objective is to preserve capital, should be in super-safe investments, such as U.S. Treasury bonds as well as FDIC-insured savings accounts and certificates of deposit.
Investors hoping to see their money grow more rapidly than those conservative investments allow must be willing to assume more risk. (Some day the stock market will come back and hopefully outperform those conservative investments.)
Where you stand: If the current market plunge is hitting the pit of your stomach, if you're suddenly having trouble sleeping, then you probably have too much exposure to stocks. Perhaps 80% of your investments are in stocks, when a more appropriate percentage would be 60%.
It's natural to overestimate your risk tolerance. When the market is climbing, our desire to get in on the action tends to override risk aversion; we think we can accept more volatility to achieve higher returns.
"Risk tolerance changes every time the market moves," said Erika Safran, a certified financial planner and partner at Financial Asset Management Corp. "The lower the market goes, suddenly everyone doesn't want to be a risk-taker. The higher the higher the market goes, the higher their tolerance goes."
So use this bear market to recognize your true risk tolerance. How much of a hit to your portfolio can you really stomach: 20%, 30%, 40%?
Adjust your allocation: Now, apply that "stomach-acid" test to set a long-term plan for allocating assets between stocks and investments that are less risky, including bonds (Treasuries, municipals, and high-grade corporate issues) and cash-equivalents (money market funds, savings accounts, certificates of deposit, Treasury bills).
A relatively conservative asset allocation mix is 40% stocks, 40% bonds, 20% cash. An aggressive mix would be closer to 80% stocks, 10% bonds, 10% cash.
"Set a course on your asset allocation that will guide you and stick to the plan," says Thomas Henske of Lenox Advisors. "If you start to deviate from the plan, if you make it more conservative on the lows, then more aggressive on the highs, you're doing the opposite of what you should do."
Also, keep in mind that this bear market has likely already adjusted your asset allocation somewhat. A month ago, stocks may have comprised 70% of your portfolio. Now, their value now may be only 50% or less.
Sticking with your asset allocation may dictate that you continue investing in stocks, even during this scary time.
"If you have a 401(k), if you're investing for college, if you're investing for your long-term retirement and you're doing it on a monthly basis, don't stop," Safran said. "It hurts, it's ugly, but this is the way serious wealth is built over the long term. The best way to make money is to invest when it really, really hurts."
As you consider your asset allocation, make sure you're setting aside enough cash for at least a year of living expenses - some financial experts say two years.
"With a couple of years of cash on hand, we're not being forced to change our asset allocation at the wrong time," said John Olson, Merrill Lynch wealth management advisor. "The important thing is to have an asset allocation up front so you don't have to sell equities after they're down for 12-months."