Managing risk in the stock market becomes more important as you get older. We all learned this from the challenging 2000 decade when the stock market (S&P 500 index) had an annualized negative return of 2.72% (excluding dividends) for the entire 2000 decade!
If you’re wondering how to manage risk in the stock market, investing within acceptable risk tolerance, increasing cash when warranted, considering valuations when investing, buying noncorrelated diversified assets that go up when stocks go down and tactical asset allocation are common risk management strategies.
Note that while I’m an AFC® (Accredited Financial Counselor), I write mostly from my own experience investing for almost 40 years in stocks, bonds, commodities, real estate, and small business.
We all know that bear markets and crashes present the most common risk for stock market investors, so let’s begin with these.
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Is a Stock Market Crash the Same as Bear Markets?
Stock market crashes and bear markets are different but related. Stock market crashes are sudden drops in the stock market. Stock market crashes are usually part of an overall stock market decline of 20% or more, which is the definition of a bear market.
How Will a Stock Market Crash Affect My Portfolio?
Some stocks do well in stock market crashes, or bear markets. Stocks that do well are usually stocks that benefit from an economic slowdown. Overall, however, most stocks move with the overall stock market. Also, most stock investors own stock index funds, which represent the overall stock market. For these reasons, most stock market crashes affect portfolios very badly, the extent depending on the depth of stock market decline.
When investing in the stock market, it’s important to remember there is (1.) stock market risk from owning individual stocks and (2.) overall stock market risk related to stock market crashes. Since broad stock market risk typically affects all stock investors, and broad markets provide valuable measurement tools via indexes for stock market risk, indexes are used to address and measure stock market risk as you’ll see I often do in this post.
How Can You Avoid Risk in the Stock Market?
You can avoid risk in the stock market entirely by simply not investing in it. The stock market is, however, a passive way to build wealth, and is considered the mainstay of an investment portfolio, while more alternative investments are not. Stocks are promoted and used for most 401K’s and other retirement plans. For this reason, it is hard for most investors to avoid risk in the stock market.
Most millionaires and billionaires become wealthy by methods other than stock market investing, such as real estate and small business. Even well known small business icons, however, such as sharks Mark Cuban and Kevin O’Leary have indicated that even they invest in the stock market.
Read my related post Owning a Business Vs Real Estate.
How Much Risk Should You Have in Stocks?
The amount of risk you should have in stocks is a factor of how much wealth you need to accumulate in order to support your lifestyle, the investing time frame to reach that necessary amount, stock market opportunities at any given time, and your personal risk tolerance. This will be different for everyone.
One of the first steps I take with financial coaching clients is to define acceptable risk from an overall wealth plan which usually includes investing in stocks.
Once desired investment results are defined, along with the acceptable risk you’re willing to take to get those results, you can estimate how much risk you should have in stocks. Stock market risk varies, however, with the valuations at any given time, so this should always be considered in addition to an overall investment plan.
Is My Stock Portfolio Too Big?
Some of my financial coaching clients wonder if their stock portfolio is too big, especially after it has increased in value over the years.
Stock portfolios can become too big when stocks make up too much of a well diversified portfolio based on the desired asset allocation among various asset classes. Often, after long bull markets, the stock portion of the portfolio becomes disproportionately big signaling that it may be time to rebalance the portfolio back to the desired asset allocation.
Portfolio rebalancing is a common strategy to manage risk in the stock market when a stock portfolio has become too big.
Calculate Stock Market Risk
You can calculate stock market risk by multiplying the total amount invested in stocks by the average amount of bear market declines. Stocks lose 36% on average in a bear market. (1.) While there is a wide range of bear market declines, this calculation can give investors a reasonable estimate to help address and manage stock market risk.
One of the worst things in life is to be caught off guard by negative experiences but this is what happens with most stock market investors.
When investing in stocks, getting caught off guard is certainly a natural occurrence since it’s easy to forget about stock market risk after getting excellent returns of 300% or more over a few years. High stock market returns are the result of bull markets.
Such stellar returns can easily distract investors from managing stock market risk with the lure of indefinite high stock market returns. This is the exact time to be attentive to stock market risk, however, since bear markets follow long bull markets that have led to excessive stock market valuations.
The good and usually overlooked reality is that at any given time, you can estimate your risk in the stock market. There is peace in knowing your potential risk because when we know our risk, we can change it if we choose. Otherwise, it can feel like we are victims of stock market risk.
For this reason, I suggest calculating your own stock market risk estimate 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.
Read my related post What Goes Up When Stocks Go Down?
How Do Bear Markets Affect Net Worth?
All stock investors want to manage stock market risk. What I have learned from investing through previous bear markets, however, is that there is a bigger question when it comes to stock market risk which relates to your overall net worth.
How do bear markets affect net worth? An economic slowdown usually accompanies bear stock markets. In addition to a decline in the value of stock portfolios, net worth can be negatively affected by the potential loss of job income from a slowing economy. Additionally, a related decrease in demand for homes can negatively affect home values, particularly high end homes.
I saw such decreasing home valuations and job losses seriously affect families financial well being in both the early 2000 tech bust as well as the financial crisis and related bear market from late 2007 to 2009.
It’s one thing to manage stock market risk. I encourage my financial coaching clients to take the next step, however, and consider net worth risk in addition to stock market risk. By having an awareness of such potential net worth risks, investors can better handle the scary hype during bear stock markets and focus on how it affects them personally.
They can also prepare for the inevitable bear markets that all stock investors experience every few years.
Read my related post How Much of My Net Worth Should I Have in My Home?
Do Stock Market Cycles Matter?
Investors are rarely encouraged to consider 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; when high valuations are paid for an asset, risk naturally increases. Near the end of bear markets, stock valuations are low. Buying stocks for 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 stock market risk.
Decide If Lowering Stock Market 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 lowering stock market risk is a major priority for you.
While this may sound crazy, many investors accept the large fluctuations in the stock market without stress. There is nothing wrong with this IF it leads to achieving your financial goals.
I personally detest major net worth declines related to bear markets, so lowering stock market risk is a major priority for me. Many investors, however, are not bothered by bear market declines.
In fact, most investors (and conventional investing methods) ignore stock risk from market cycles for the most part in favor of long term buy and hold investing. This is because we all like to do things in the simplest way.
Also, investors are encouraged to ignore market cycles in traditional investing since investors often buy high and sell low when deviating from long term passive (buy and hold) investing. In my opinion, the counter to this is becoming a more educated proactive investor, however.
It’s important to address that trying to invest around cycles can lead to under investing, or missing at least some of the upward movement for the benefit of lower risk. Most older investors appreciate lower risk, which leads to my next point on why and how to manage risk in the stock market.
Read my related post How to Know If the Stock Market Will Go Up or Down.
How Age Affects Stock Market Risk
The younger an investor is, the higher their risk tolerance is. This is because younger investors have decades to recover from stock market losses. Older investors simply don’t have that advantage.
One of the most important considerations in managing stock market risk is time and age.
If you’re 30 you have decades to earn money, save and invest before retirement, assuming you plan to work until after midlife.
If you’re 40 you still have over two decades to accumulate wealth before retiring if you choose to retire a little early at age 60.
But if you’re 50, you have only 15 years to build wealth before retirement if you retire at 65. And 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.
Stock Market Risk and Retirement
Someone who was retiring at 55 in 2000 experienced that annualized negative stock market return of .95% (including dividends) for the next 10 years! (Read my related post Stock Market Returns 2010 through 2019.)
But someone who retired at age 55 in 2009 experienced a total return of over 300% in the next 10 years!
This is why considering stock market cycles and current valuations at any given time is so important in managing stock market risk.
Studies have shown that stock market investors experiencing bear markets in the years just prior to or just after retirement usually has a detrimental effect on retirement plans by lowering the amount that can be withdrawn to live in retirement.
Below is my video about this risk, called Sequence of Returns Risk.
Regular readers know that I encourage alternative income streams from a multitude of options to lower the risk of running out of money in retirement and avoid relying on withdrawals.
Strategies to Manage Stock Market Risk
Now, let’s assume you do want to reduce stock market risk as most investors do. The most common ways to accomplish this are below.
Increasing Portfolio Cash
Simply increasing or decreasing the percent of investment funds in cash (money market accounts) is an easy way to manage stock market risk. Information about current and historical cycles and valuations can be useful tools here.
Diversify Investments
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, your portfolio is diversified into Treasury bonds, commodities, gold, money market, or other assets, as many investors are, it’s very unlikely your portfolio has declined as much as the overall stock market.
Diversifying into investments that go up when stocks go down and moving 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 and gold, but this is not always the case as you’ll see in my article What Goes Up When Stocks Go Down.
Diversify income
Increasing and diversifying income is another somewhat overlooked way to lower stock market risk but can be extremely effective for retirees, in particular.
This is because investors who are relying on their investments to live 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 may have read here, I encourage alternative income streams from small online business or real estate rentals.
While creating such diversified new income streams is more trouble than collecting stock dividends or making withdrawals, it can be fulfilling, rewarding, and significantly lower risk while also building wealth ahead of and during retirement. We certainly found this to be the case.
Should You Use Stop Loss Orders to Manage Stock Market Risk?
Stop loss orders are fairly simple and give stock market investors a lot of risk control. Investors can set up stop loss orders to automatically trigger based on their acceptable risk tolerance. Investors should be aware that stocks can quickly rise just after stop losses are triggered, however, and that stop loss orders are not always filled at the price investors hoped to get.
Does Tactical Asset Allocation Work for Managing Stock Risk?
Tactical asset allocation can be an excellent way to manage stock market risk because it invests in diversified noncorrelated assets which are bought and sold based on opportunities at any given time instead of simply buying and holding regardless of presented opportunities. Many tactical investing strategies rotate out of stock markets way before bear markets reach their worst stage if not before they even become bear markets.
Tactical asset allocation strategies have become one of my favorite ways to invest our core stock and bond portfolio due to their ability to generate returns higher with less risk than passive stock and bond index investing. Most tactical asset allocation strategies have been developed by lifelong financial and stock market experts.
The good thing for investors concerned about stock market risk is that tactical asset allocation strategies work regardless of stock market direction. In fact, many of the same tactical asset allocation strategies now available to individual investors are used by financial advisors and high net worth wealth managers.
Using Options to Limit Stock Market Losses
Options are commonly used to manage stock market risk by investors and financial institutions. Below are two simple option strategies used.
Buying Put Options to Manage Stock Risk
A common method used by funds and wealth managers to manage stock market risk is purchasing put options. When stocks go down in value, put options go up in value.
Since options decay simply from time and eventually become completely worthless, however, 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. As the seller vs buyer of options, the time decay factor from options 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.
Covered calls, however, are subject to stock market risk since the stocks against which the call options are sold must be owned. As such, selling covered calls should be part of that overall wealth plan which defines acceptable stock market risk.
Stock Market Risk Management Summary
it’s worth repeating that managing stock market risk begins with an overall wealth plan that defines risk tolerance and investment goals. Knowledge about how your own net worth is likely to be affected by bear stock markets is also an important step.
This is followed by a conscious decision on how much risk you want from investing in stocks and choosing an asset allocation that aligns with that decision.
Then you’ll want to choose the best strategy for you if you find it is necessary to lower stock market risk.
The best place to start is with my Ultimate Wealth Plan where I outline 49 ways to lower financial risk. You can get it here now.
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Sources:
- https://www.hartfordfunds.com/practice-management/client-conversations/bear-markets.html
