Virtually every stock primer includes one of those quizzes designed to help investors figure out how rough the market's waters can get before they'll toss their cookies, sell everything, and hide out under the bed with a bag of cash.
Can you really guess how you'd react if a big chunk of your money suddenly evaporated? Now it's time for the real test. The last few months of market gyrations present a great opportunity to discover your tolerance for real-life risk -- and retool your investments accordingly.
A pop quiz
Imagine that the stock market, as measured by the Standard & Poor's 500 Index, dropped 12% over six months. Would you:
A. Go bargain-hunting.
B. Stay put, while nervously reminding yourself that you're investing for the long term.
C. Sell everything and park your cash someplace safe.
D. Thank your lucky stars that you keep your life savings invested in Hummel figurines.
That's no hypothetical statistic. The S&P 500 has dropped 12% since November. How have you weathered this downturn? Answer honestly, and let that answer tell you whether you've taken too many -- or too few -- risks with your money.
Highs and lows
Let's start with the bargain-hunters. If you're salivating over this market drop like a hungry dog at a barbecue, you're probably taking appropriate risks with your money. You might even be happier taking on a few extra risks, since you're willing to ride out the volatility for the opportunity to see great gains.
You don't need me to tell you to dig into some research and start looking for a great small-cap buying opportunity. You've got a great chance to get a good stock at a bargain price.
Think you'd be crazy to buy into this market? If you're truly tempted to sell everything because this market's roller coaster ride keeps you awake at night, you need a dose of diversification.
Take a serious look at your asset allocation. Make sure you keep enough cash on hand to feel safe. Then, decide whether you need a bigger dose of bonds or, alternatively, international stocks. Both tend to move out of step with U.S. stocks, and they can buoy your portfolio in rough waters.
No investor is an island
For everyone else who frets a little bit, but plans to sit tight, it's time for a little pep talk. Your biggest lesson from this downturn is that careful stock selection, diligent diversification, and intelligent asset allocation cannot completely mitigate the risk that the market will occasionally go bonkers.
Market downturns can drag everything and everyone into a nosedive. When heavyweights like Bank of America (NYSE: BAC ) , Citigroup (NYSE: C ) , and JPMorgan Chase (NYSE: JPM ) started to slide, they couldn't help but bring everything else down with them. All three rank among the 20 largest holdings of many plain-vanilla index funds.
Instead of worrying, take a lesson from the bargain-hunters. You already know that stocks have historically offered the best opportunity to watch your money grow, and you're committing your money to the market for the long haul. If you keep your eye on that distant horizon, you'll see a buying opportunity, too.
For more reasons to put on a happy face, see: