The sleep test: lessons from a bear market
Unless you’ve completely avoided the news for the last few weeks, you know the global economy is in trouble. No one knows how bad it will be, when the bottom will hit, or how long it will take to recover. But plenty of “experts” think they know the answer.
So what is an investor to do during this time? It’s pretty obvious what an investor shouldn’t do - sell in a panic (read: “low”), and buy when the market picks up (read: “high”). Remember that investors who stayed in the market during the Great Depression did just fine over the long run. And those who weren’t investing for the long run shouldn’t have had much in the stock market in the first place. In other words, your best bet during a market like this is probably to stick tight.
Unless you can’t sleep. If the 14% drop in the US stock market is keeping you up at night, you have too much invested in stocks. This is “the sleep test.”
The sleep test is a handy way to figure out your risk tolerance. If the market drops 14% and you panic, then your asset allocation exceeds your risk tolerance. After all, if you’re only 20% in stocks, the 14% dip is only a sleep-worthy 3% decline, potentially offset by your other investments. And if you can’t sleep following a 3% decline, then you should seriously rethink whether equity investing is for you. For most people, there is probably somewhere between 20% equities and 100% equities at which they can sleep well in the midst of an economic crisis. This is your risk tolerance.
So if you can’t sleep, consider decreasing your equity holdings. But there’s a catch. You can’t buy more stocks when the market picks up. You’ve got to stick with your asset allocation even if we see a 20-year bull market. Anything else is performance chasing.
Personally, I’m going to stick tight. I understand that we’re in an unprecidented financial crisis, but every crisis is unprecidented. And I think it is extremely likely that the US business climate will be strong overall for the next 20 years, which means that it is extremely likely that stocks will do well. So instead of panicking or chasing performance, I’m going to stick to my 75%/25% asset allocation.
