On May 12, the Nasdaq Composite briefly touched a new 52-week low of 11,108.76, which represented a drawdown of more than 30% from its all-time high (recorded in Nov. 2021). Yet the sell-off has been much worse for many individual stocks. Even after a strong rebound for the index the following day, shares of Amazon are down over 40% from their all-time high. Companies like Netflix are down 75% from their all-time highs.
When markets are in dire straits, people often feel helpless and search for actionable insights. It's a classic fight-or-flight response, but sometimes the best course of action is to be patient and let time work in your favor.
However, it's important not to confuse patience with complacency as there are many valuable lessons investors can take away from the 2022 bear market and apply to their investment strategies down the road. Here's why I think the importance of portfolio allocation and position weightings is a lesson that could be life-changing for investors -- especially those that are experiencing what could be their first prolonged bear market.
Portfolio allocation typically refers to the breakdown of different asset classes in a portfolio, including equities like index funds, exchange-traded funds, and individual stocks, plus bonds, commodities, precious metals, collectibles, cryptocurrency, U.S. treasuries, cash, etc.
It may seem routine, but predetermining your ideal allocation across these different assets can be a lifesaver during both bull and bear markets. For example, during a bull market, the equity and crypto portions of a portfolio can become larger than intended due to rising values. This isn't to say that an investor should sell positions simply because they've gone up. But if the investment thesis can't support a more expensive valuation, then it's okay to rebalance a portfolio to the desired weighting.
The reverse is true during a bear market where falling equity, bond, and crypto values can lead an investor to be underweight riskier assets and overweight cash and cash-equivalent assets. To adjust for that imbalance, an investor can begin to build positions in stocks, bonds, or crypto when prices are lower and return their portfolio to the desired level by asset class. Next comes the even bigger lesson.
Understanding position weightings
There's an old idea that an investor's equity allocation should be roughly 100 minus their age, so a 40-year-old investor should have a portfolio made up of 60% equities. Given equities are likely going to make up the largest percentage allocations for most folks (especially if you include retirement portfolios) for the majority of their working lives, it's strange that we don't hear more conversations about the importance of position weightings.
One of the worst mistakes an investor can make is taking on unnecessary amounts of risk with a large percentage of their money. A risk-averse investor, for example, may prefer to have the equity portion of their portfolio entirely in safe dividend stocks to boost their passive income stream or name-brand stocks they can count on to outlast a stock market crash. A risk-tolerant investor may find themselves (often accidentally) allocating most of their equity portfolio into high-risk, high-reward stocks. Even for an investor with a multi-decade time horizon, it's rarely a good idea to make such outsized bets.
In many ways, the greatest investors aren't the ones that pick the best stocks but rather the ones that manage risk well consistently. The crash we've seen in growth stocks, particularly smaller unprofitable growth stocks, has been a nonissue for many investors. But for those that were overexposed to that investment category, the pain has been excruciating.
Where to go from here
As much as we wish we could turn back the clock and correct mistakes before they happen, the truth is that the best course of action is to simply learn from what went wrong so it doesn't happen again. I think for most folks, earmarking anywhere from 10% to 30% of their portfolio to riskier equity investments and crypto is the best way to gain upside potential without incurring an outsized loss that can take several years to recover from.
Many growth stocks are down 70% or more from their highs. If a 40-year-old investor with 60% exposure to equities is invested almost entirely in riskier stocks, we're talking about very steep losses. But if the exposure to riskier stocks is only, say, 20%, then even a 70% decline is still just a 13% or 14% loss for the overall portfolio -- which isn't too bad. Granted, many large companies are down big off their highs too. But the lesson here is that by simply predetermining asset allocations and risk weightings within those asset classes, an investor can avoid catastrophic losses while still exposing themselves to excellent returns that can be compounded over time.
The temptation to achieve outperformance by taking on more risk can grow when folks are getting rich off meme stocks and random altcoins. But as we have seen in the meltdowns in those markets, risk is never free. And as much as we wish we could punch our ticket to the moon with a speculative gamble, the downside is rarely worth it.
By sticking to a game plan that suits your personal risk tolerance and time horizon, an investor can leave room to get creative and have fun by opening starter positions in companies they are interested in through a responsible allocation that ensures no matter what happens, their overall financial well-being isn't tethered to the success of risky assets.
Taking relatively small stakes in exciting new companies is the best way to give a growth story the time it needs to play out. If the position is reasonable, you'll feel less stressed if the value falls considerably. In sum, investing in growth stories without jeopardizing your overall financial health is a balanced approach that will help you sleep at night and add optionality to get creative and think outside the box with your investment portfolio.