Thursday, 29 October 2009

Losing Sleep over Stocks? Figure Out Why Before Bailing Out

"If you cannot sleep at night for worry about your investments, then you need to reduce your allocation to stocks and increase fixed income or GICs." This common measure of risk aversion and advice needs examination. Not being able to sleep is a fear reaction and surely a bad thing that should be dealt with, but the under-lying reason can suggest completely different fixes.

In his book Live It Up Without Outliving Your Money, Paul Merriman provides useful ideas to examine the issue: "Risk is a possibility that you invite into your life in which you could lose something important." He also says: "There are two categories of risk: objective risk, which can be measured, and emotional risk, which depends on each person's perceptions."

With that in mind, here are a few ways in which perceptions might be incorrect and some suggestions for anti-dotes:
  • What is the objective risk of stock volatility and returns? - if you were surprised that the 2008 market crash could ever happen, then learning about the short term variability and the long term returns of stocks and those of other asset types will greatly reduce the anxiety - read books such as Richard Deaves' What Kind of Investor Are You? and Keith Matthews' The Empowered Investor.
  • Will you lose? - your time horizon is critical. For a person investing for the long haul 25 or 30 years down the road to retirement, even a big drop in a year can and will be regained by sticking to it. Fixed income has its own risks such as inflation, interest rate, downgrade/default and reinvestment risk, which the investor also needs to consider.
  • Do you know the importance of the potential loss? - do you really know what the negative impact of the loss will be? If you do not, then it is likely you do not have a plan in place and the solution is to make an investment plan for life goals, as previously discussed in Setting Investment Objectives. Perhaps taking the risk is necessary. As Merriman says, "Take too much, and you can compromise your future by incurring big losses that you can't afford. Take too little, and and you can compromise your future by depriving yourself of the return you need." You need to know where you stand first. Then you may decide to sacrifice a possibly wealthier future for a more certain but less prosperous one, or vice versa. Of course, the golden rule is always that if you don't need to take the risk, then don't take it.
There is a big difference in emotional reaction between consciously facing known risks or adversity and having them appear as a nasty surprise. People constantly face tough situations with equanimity and sleep very well when they know what is going on and when they feel they have made the best decision possible, even when they cannot control the situation, such as stock market ups and downs. Loss of sleep over investments may be a sign of true danger or a reflection of a correctable phobia. Knowing the difference enables one to take the right corrective action. A shift into fixed income may or may not be worthwhile. Maybe it is not sleeplessness but falling asleep at the wheel that one should really worry about.

1 comment:

Anonymous said...

What a great resource!