Early into the second part of 2022, it might feel like the stock market is repeating its first-half performance: choppy performances pulled lower by a basket of worries.
So if an investor had cash to spend, would they spend it the same way now as they did in January?
That depends on a person’s risk tolerance, and that risk-reward gambit feels a lot different in a bear market amid inflation at a 40-year high and persistent worries of an impending recession.
“During a bull market, investors say they are comfortable staying the course if the market goes down,” said Shane Sideris, managing partner at Synchronous Wealth Advisors in Santa Barbara, Calif. But when the market is on a downward spiral? “That can be a very different story,” he said.
Sideris is dealing with the “night and day” difference between the market risks that some of his clients have said on paper they can withstand, and what they are actually willing to live with. “The biggest thing is figuring out why they want to sell, why they want to go to cash,” he said.
“Research shows that those engaged in abstract thinking are more likely to take risks when compared to those with a concrete mindset,” said cognitive scientist Sian Beilock, author of “Choke, What the Secrets of the Brain Reveal About Getting It Right When You Have To.”
“Thinking in the abstract also makes us more prone to focus on the potential positives of an action, thus often unprepared to deal with the reality of loss,” said Beilock, who is also the president of Barnard College.
“‘We’re still seeing net buying. I will acknowledge it’s not nearly as aggressive.’”
To be sure, some risk-tolerant investors see buying opportunities. For example, many retail investors aren’t getting tired of buying up their favorite stocks, at least not yet, according to analysts at Vanda Research.
“We’re still seeing net buying. I will acknowledge it’s not nearly as aggressive,” Steve Sosnick, chief strategist at Interactive Brokers IBKR, +1.71%, told MarketWatch.
Still, he added, “there’s a litany of different ways investors pulled back the risk. Crypto being the most obvious.” Bitcoin BTCUSD, +0.36% has fallen more than 70% from its record high in November.
On Thursday, the Dow Jones Industrial Average DJIA, +0.82%, S&P 500 SPX, +0.99% and Nasdaq Composite COMP, +1.25% found a firmer footing after finishing in positive territory on Wednesday on the back of the Federal Reserve’s June minutes in which officials signaled that they were ready to follow through with more tightening.
Last month, the central bank increased a key interest rate by 75 basis points in an attempt to tame inflation, making it the single-largest hike to the benchmark rate since 1994.
Of course, investors can’t control the Fed’s next move, but they can control what they do next. No one can guarantee market outcomes or investment returns, but here’s how to approach and evaluate the risks:
1. Risk capacity vs. risk tolerance
If the markets weren’t supplying enough lessons in risk, questionnaires — like this one from Vanguard or this one from the University of Missouri — can give people a glimpse on how their risk appetite stacks against others.
But there’s a difference between the investment loss a person’s portfolio can withstand and what their brain can handle. Ideally, a person’s “risk capacity” matches their “risk tolerance,” Sideris said.
(Risk tolerance relates to how much risk investors are willing accept. Risk capacity is how much investors are able to accept, given their finances, age and investing timetables.)
However, the two rarely align, he added.
“Unless you are actively spending down your savings (i.e., retirement) or are about to spend down your savings (i.e., near retirement), your risk capacity likely has not changed. Most people’s risk capacity doesn’t change much as a result of market volatility. But their risk tolerance can change considerably. This is human nature,” he said.
“Risk tolerance relates to how much risk investors are willing accept. Risk capacity is how much investors are able to accept.”
There’s also a gender divide, Beilock said. “While men are more likely to be overly confident in their financial knowledge and to take more financial risk, women tend to be more risk averse and doubt their own financial knowledge.”
Girls can become anxious about math at an early age, Beilock’s research has found, and that can translate into worries about money management and investments later in life. “Since uncertainty exacerbates anxiety, times of financial uncertainty are more likely to make investors, especially women, feel more anxious about their financial future,” she said.
2. Harnessing healthy emotions
Financial advisers constantly tell clients is to avoid investment decisions driven by emotions, headlines of the day and short-term information. That’s sound advice, but experts said people can still harness their emotions for the good of their portfolio and their money mindset.
One start is finding one’s “sleep-at-night number,” said Lauren Gadkowski Lindsay, a certified financial planner at Beacon Financial Planning based in Houston, Texas.
That’s the amount of money a person feels they always need quick access to in the event of an emergency. With that amount tucked aside, Lindsay said a person can build the rest of their portfolio.
Writing it out and talking it out can help, Lindsay said. “I do think it’s important go back to basically say what you are worried about in this market.”
“Financial advisers tell clients is to avoid investment decisions driven by emotions, headlines of the day and short-term information. ”
“Every investor needs to do a periodic gut check when markets decline,” Sosnick said. “If you are just stressed by a 1%, 2% drop on any day, if that’s extremely upsetting, then you are carrying too much risk.”
There’s various ways to shed that risk, he said. It could be moving to stocks with lesser volatility, measured by its “beta.”
(The stock market has a beta value of “1” — any stock above that number has more volatility than the stock market, meaning it will rise more than the market when the latter rises, and vice-versa for a number below “1.”)
Reducing risk could entail more bond exposure or more money into cash, Sosnick said.
As the market recovered after plummeting in the pandemic’s early days, there weren’t “gut check days” through much of 2020 through fall 2021. “Since then, quite frankly, we’ve have a lot,” Sosnick said.
3. Recession-proofing for the risk averse
There’s varying opinions on the certainty and strength of an incoming recession, but some investors may not yet have seen the worst market bottoms.
There will be stocks selling at “bargains” for risk-inclined investors, Sosnick said. (Oaktree Capital’s founder, Howard Marks, feels the same way.)
But there’s ways to stay cautious, Sosnick said.
“What we’ve seen overall is a renewed focus on sustainable earnings and sustainable cash flows,” he said. There’s various ways to measure a company’s strengths and weaknesses, but it’s worth keeping an eye on the data surrounding cash flow, Sosnick said. In uncertain times, look at how much cash-on-hand a company has.
On the other hand, Lindsay said investors can scale down their risk exposure by eyeing capital preservation mutual funds, or conservative-leaning balance funds.
Just don’t think it’s a complete protection from loss, Lindsay noted. Bonds, whether in these types of funds or elsewhere, have been taking hits too. “Right now, there’s nowhere to run, nowhere to hide,” she said.
“One move for the risk averse: Check how the money is actually being deployed and invested in a person’s 401(k) plan.”
Another move for the risk averse? Check how the money is actually being deployed and invested in a person’s 401(k) plan, Lindsay said. For example, a target date fund’s allocation might not match a person’s comfort. One client has money in funds designed for the lowest risk exposure in 2030 and 2035, despite the fact they are planning to retire years later.
Lastly, remember there’s risk in complete avoidance.
Suppose a person poured $500 a month into the S&P 500 beginning in 1982. Then the Great Recession’s downturn scared them into cashing out their money in March 2009. They would have accumulated approximately $475,000, Sideris said.
If they stayed the course, even with the recent market dips, Sideris said they would have amassed roughly $3.2 million through the end of June.
Of course, they’d have to live through multiple recessions, rate hikes, bear markets, bouts of global instability and one pandemic during that 40-year span, Sideris said.
“No one actually stays the course. Everyone knows they should, but it’s really freaking hard to do it.”
Read also:
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