How to Manage Risk in the Stock Market

Managing risk in the stock market becomes more important than ever after age 50. We all learned this from the “lost decade” when the stock market (S&P 500 index) had an annualized negative return of 2.72% (excluding dividends) in the first 2000 decade.  

If you’re wondering how to manage risk in the stock market, being aware of your risk, increasing cash, considering valuations, and buying assets that go up when stocks go down are common strategies.  

While I’m an AFC® (Accredited Financial Counselor), I write from my own experience investing for almost 40 years without an agenda since I do not manage wealth for others.   

It’s easy to forget that there is (1.) stock market risk from owning individual stocks, and (2.) broad stock market risk. Since broad stock market risk affects all stock investors, that will be the focus of this article.  

Risk Vs Opportunity 

You may have noticed that I focus a lot on risk here at Retire Certain. Part of the reason for this is that I am now an older investor who likes low risk.  

But the other reason is that the stock market had been going straight up for almost a decade when I began this blog. In good conscious, I just can’t write about investing in stocks without first addressing the risks.  

The flip side of stock market risk, however, is the opportunities to build wealth that surface after bear stock markets. This means that stock market risk as it relates to bear markets can be a good thing for informed and proactive investors, so keep reading.     

Estimate Stock Market Risk 

One of the worst things in life is to be caught off guard with negative experiences but this is what happens with most stock market investors. 

This is a natural occurrence since it’s easy to forget about stock market risk when you’ve gotten stock market returns of 200% or more over a few years! 

But this is the exact time to be attentive to stock market risk since bear markets follow bull markets. 

Gain Control 

Stock market risk can feel worse than it is in the midst of a bear market when the news is full of nonstop reports of declines of 50% and more. This is scary.  

When you hear this, it can feel like your entire investment portfolio has dropped 50%! If, however, you’re diversified into Treasury bondsmoney market or other assets, as most investors are, it’s very unlikely your portfolio has declined that much as explained more below.  

The real question is this: How much has your net worth dropped as a result of a bear stock market? By knowing this instead of focusing on the stock market decline alone, you can avoid the scary hype and focus on how it affects you 

Here’s the good and often discussed reality: At any given time, you can estimate your risk in the stock market. There is peace in knowing your risk, because when we know our risk, we can change it if we choose.  

It just doesn’t feel that way. It feels like we are victims of stock market risk.  

Here is my article where I step you through estimating your stock market risk at any given time based on facts and history. I suggest doing these few simple steps at least quarterly.  

By doing this, you are taking responsibility for managing stock market risk. Simply doing so lowers your risk and makes you a more proactive and empowered investor.  

Being Aware of Stock Market Cycles 

Investors are rarely encouraged to consider long stock market cycles before investing  but doing so lowers investment risk considerably. 

This is because near the end of a rising stock market valuations are high. Any time you pay high valuations for an asset, you naturally increase risk.  

And near the end of bear markets, valuations are low. Buying stocks at less than average historical valuations naturally reduces stock market risk.    

This means that considering long term market cycles and related valuations before investing in stocks lowers risk. This is something that all stock market investors can do to lower risk.    

Decide If Lowering Risk Matters  

After you’ve gotten a good handle on how much stock market risk you have, and checked to see where the stock market cycle and valuations are based on history, decide if you really want to lower your stock market risk.  

While this may sound crazy, many investors accept the fluctuations in the stock market without stress. There is nothing wrong with this.   

Most investors (and conventional investing methods) ignore market cycles for the most part in favor of long term buy and hold investing because most investors want investing to be easy.  

Lowering Risk Can Have a Downside 

It’s important to realize that whenever you invest around cycles, you  can miss part of the upward movement for the benefit of lower risk. 

Most investors near our age appreciate lower riskwhich leads to my next point on why and how to manage risk in the stock market.   

Years to Build Wealth from Stocks 

One of the most important considerations in managing stock market risk is time.  

If you’re 40 you still have over two decades to accumulate wealth before retiring unless you want to retire early, as many people do now. 

But here’s the reality:  

If you’re 50, you have 15 years to build wealth before retirement if you retire at 65.  

If you’re 60, you have only 5 years to build wealth before retirement at age 65. 

The fewer years you have, and the less money you have saved, the more important managing stock market risk is for investors.  

Age and Stock Market Cycles 

Someone who was retiring at 55 in 2000 experienced that annualized negative stock market return of .95% (including dividends) for the next 10 years! 

But someone who retired at age 55 in 2009 experienced a total return of over 300% in the next 10 years!  

Only you can decide how much stock market risk you want to have at any given time in your life.  

And it begins with estimating your stock market risk at any given time and making a logical decision based on your own net worth, age, and ability to handle the risk from investing in stocks.   

This is why blanket investment advice  using standard asset allocations bother me. Not everyone should necessarily have 60% in stocks and 40% in bonds (or similar allocations) at age 50 or any other age.  

What they should have instead is an awareness that they can choose their risk from a place of knowledge and empowerment.  

The bottom line is that awareness and education reduce stock market risk more than anything else because they guide you to the right decisions for you personally.  

Strategies to Manage Stock Market Risk 

Now, let’s assume you do want to reduce stock market risk. The most common ways to do this are by: 

Increasing Portfolio Cash 

Simply increasing or decreasing the percent of wealth you have in cash (money market accounts) is an easy way to manage stock market risk.  

Cycles and valuations data can be good guides to use here.  

Diversify investments  

Diversifying into investments that go up when stocks go down and out of these investments as stocks go up is another good strategy to manage stock market risk.  

Typical assets that go up when stocks go down are U.S. Treasury bonds, gold and oil, but this is not always the case. Read my article What Goes Up When Stocks Go Down for more about this.   

Diversify income 

Increasing and diversifying income is another way to lower stock market risk that is rarely mentioned but is extremely effective.  

This is because investors can add an income stream or two that will get them through bear stock markets without having to sell stocks at losses.  

Not only this, but income streams can be created that are noncorrelated with stock and bond investments.  

As you have read here, I love alternative income streams from small online business or real estate rentals. Both can be somewhat passive.  

Is creating diversified new income streams more trouble than collecting stock dividends? Yes! 

Can it be fulfilling, rewarding and significantly lower risk while also building wealth ahead of and during retirement? We found this to be the case.  

Using Stop Losses 

Finally, you can always put in stop losses to manage stock market risk. This is fairly simple and gives you a lot of risk control.  

Buying Options to Limit Stock Market Losses 

Options are commonly used to manage stock market risk by fund and wealth managers.  

 Selling Put Options   

A common method used by funds and wealth managers to manage stock market risk is by purchasing put options. Since options decay simply from time and eventually become completely worthless, this can be risky for individual investors who are inexperienced with options 

Selling Call Options 

You may have read here that I like to sell covered call options for extra income on stocks. It’s important to realize that as the seller vs buyer of options, the time decay factor is on your side.  

Selling call options against stocks you own slightly lowers stock market risk since the income from the calls offsets the cost of your investment in a stock. 

Stock Market Risk Management Summary 

Managing stock market risk begins with knowledge about how your own net worth will be affected by bear stock markets. This is followed by a conscious decision how much risk you want from investing in stocks.  

Then you’ll want to choose the best strategy for you to lower stock market risk if that is what you desire 

  

Wealth Building Strategies eBookIf you’re interested, get my newsletter and grab my free eBook on wealth building strategies that generate income streams in retirement, too.  

 Thanks for reading. If you enjoyed this post, please share it with others on your favorite social media.

 

Disclaimer: Nothing in this post is meant to be taken as personal financial advice. Only you are responsible for your own money.

Leave a Comment

Your email address will not be published. Required fields are marked *