Pop quiz: What would you do if stocks lost 30% of their value in the span of two months?
a. Sell your entire investment
b. Sell part of your investment
c. Hold on to your investment
d. Invest even more
This question is typical of the risk tolerance questionnaires you're usually required to complete when you start investing or meet with a financial advisor. But we're pretty lousy at predicting how we'll actually react when we lose money.
When the market is up, "D" seems like the obvious answer. Consider that if you'd dumped money into an S&P 500 index fund on March 23, the low point for the index during the coronavirus market crash, your investment would be up nearly 47% today.
But did you really rush to invest more money in March -- back when we had no idea how much further it could crash?
If your hypothetical reaction doesn't jibe with how you actually reacted when the market imploded, it's time to review your risk tolerance and rebalance your portfolio if necessary. But you need to take action ASAP, especially if you're worried about a second stock market crash.
Why now is the perfect time to review your risk tolerance
Your goals, your age, and your investing time horizon all affect your risk tolerance. But your feelings about risk matter, too. So now is an opportune time to reassess, because the crash is still fresh in your mind.
Logically, you may know that you shouldn't fear another crash because short-term fluctuations have little impact on long-term performance. But if watching the market in March sent your blood pressure skyrocketing and left you unable to sleep, you need to review your risk tolerance. Accepting lower returns in exchange for reduced risk may be worth the peace of mind.
On the flip side, maybe you realized your risk tolerance is higher than you thought. Your memory of the rally that followed the crash is also fresh. How would you have felt if you'd missed out on that surge?
Should you rebalance right now?
Rebalancing is simply when you shift around your asset allocation. If you've realized your risk tolerance is higher or lower than you originally estimated, you may need to rebalance.
To reduce your risk, you'd typically increase the amount you have invested in bonds rather than stocks. If you're seeking greater risk (and the chance of greater returns), you'd shift more to stock investments.
Beyond that, you may also want to rebalance within asset classes if you've invested heavily in individual stocks or bonds. Reallocating money from stock in a single company to a total market index fund reduces your risk by diversifying your portfolio.
Just keep in mind that not taking enough risk could jeopardize your retirement. You need some risk if you want decent returns. The most conservative investments often barely keep up with inflation.
When is it too late to rebalance?
The worst time to rebalance is when the market has already crashed. You're selling your assets before they've had time to recover. Often, the decision is driven by panic, rather than your long-term interests.
Ideally, you rebalance because your life circumstances or investment goals have changed, rather than in response to the market. But if you've realized that your risk tolerance is a lot lower than you estimated, rebalance now while stocks are still high.
If your risk tolerance and your portfolio are already in sync, an emergency fund beats rebalancing as a weapon against short-term market volatility. Having cash reserves gives you the safety net you need when the stock market goes wild.