Lately the stock market has been moving up and down pretty rapidly. With all the fluctuations, you may be taking a look at your own investment portfolio and wondering whether the stocks you own might be exposing you to too much risk.
In future letters, we will discuss the difference between buying stocks through mutual funds and buying stocks as individual securities. For now, let’s assume you own stocks through a diversified mutual fund, possibly through an employer-sponsored 401(k) plan or an IRA.
Whenever stock markets are busy (which is pretty often), you are going to hear a lot of very smart people making predictions about the stock market and what it will do in the short term.
Despite their convincing arguments and impressive resumes, nobody really knows what the short-term future looks like for stocks. It’s best to accept the possibility that we could be in for a stock market storm.
Once you have accepted the potential for stormy stock markets, asking yourself the following three important questions can help you know what (if any) action to take:
Can I afford to weather the storm? Perhaps the biggest risk to owning stocks is the need to cash out when prices are temporarily down. Never invest money you will need in the next few years, because you may need to sell when prices are ridiculously low. Instead, only invest money in stocks if you can afford to hold on for the long-term.
What reward might I get for weathering the storm? It’s a good idea to set appropriate expectations concerning the rewards for holding stocks. If you think that stocks are going to make you rich in the next several years, you’re probably in for disappointment. Right now, after several years of pretty consistent growth, most stocks aren’t super cheap. However, even considering today’s slightly higher stock prices, stocks on average are still likely to outperform other types of investments over the long term, such as high-grade government bonds. Keeping your expectations realistic will prevent disappointment and give you confidence in your investment decisions.
Is weathering the storm worth it? Now that you’ve determined how much you can afford to invest in stocks, and you have set a realistic expectation concerning future returns, you’ve got to decide whether you really want to experience the ups and downs that come with owning stocks. This is a personal question because each investor has a different ability to tolerate market volatility. Stocks are not for everyone. I can tell you from personal experience, market drops can cause a sensation in the stomach not unlike seasickness. It is important to know what you are in for before you get into stocks, because the last thing you want to do is bail out in the middle of a stock market panic.
Focusing on the long term and asking the above three questions can help you make the right investment choices today, and can also help you prepare for – and make it through – the next stock market storm.