All the Right Reasons

Jonathan Clements  |  November 18, 2017

WHAT’S A GOOD REASON to dial down your stock market exposure? A year after Donald Trump was elected president, many folks are still smarting from their decision to bail out of stocks. Clearly, we shouldn’t lighten up on shares just because we don’t like the guy in the White House.

We also shouldn’t bail out just because stocks sport high price-earnings ratios and skimpy dividend yields. No doubt about it, stocks today are expensive. Those valuations are crucial in estimating likely long-run returns—and those estimated returns should, in turn, drive how much workers save and how much retirees spend.

But while rich valuations make lower long-run returns and a severe market decline more likely, they aren’t a sell signal. Indeed, I’ve been writing about the stock market for 32 years, and in every one of those years folks have complained that stocks were expensive.

We also shouldn’t sell simply because the current bull market is almost nine years old or because major market indexes are hitting new highs. Remember, stocks rise over time and in most years, so a string of winning years and new highs shouldn’t be any great surprise.

So what should prompt us to sell? Forget trying to forecast the market’s short-term direction—always a fool’s errand—and instead focus on risk. With that in mind, I see five good reasons to trim a portfolio’s stock exposure.

First, you should ease up on stocks if the current bull market has left you with far more of your portfolio in stocks than you intended. Over the long haul, this sort of rebalancing will tend to hurt returns because you’ll usually be selling stocks, which should be your portfolio’s best-performing asset class. But rebalancing also keeps your portfolio’s risk level under control, and that’s even more important.

Second, skyrocketing share prices may have put you far closer to your financial goals than you expected at this juncture. Result: From here, you can likely reach your nest egg’s target value while taking less risk, and that might cause you to throttle back on stocks.

Third, you probably ought to ease up on shares over the final 10 or 15 years before you retire. With your paycheck about to disappear, replaced by the need to sell securities on a regular basis to generate spending money, you’ll likely want to boost your holdings of bonds and cash investments. Similarly, if you have money in stocks that’s earmarked for other goals, such as a house down payment or college costs, you should probably move it out of stocks when you’re five years from needing the money, and perhaps earlier.

Fourth, you might trim your stock holdings if your financial situation changes and you can no longer afford to take so much risk. That might happen if, say, you leave a secure job to launch your own business. Now that your paycheck is so iffy, you might compensate by taking less risk with your portfolio. You might also ease up on stocks if you have barely enough for retirement and a big market decline could badly derail your golden years.

Finally, you might scale back if you find you don’t have the stomach for risk that you earlier imagined. Here, however, we enter treacherous territory. The fact is, our personal tolerance for risk isn’t stable—and it often changes at just the wrong time: We discover a newfound bravery after stocks have posted hefty gains and grow squeamish after a big decline.

My advice: Try the risk tolerance trick I mentioned in an earlier blog: First, think about the value below which you’d never want your portfolio to fall. Next, calculate how much you’d lose if stocks tumbled 35%, which is the average bear market decline. Let’s say you have $650,000 saved, with $150,000 in bonds and $500,000 in stocks. How’d you feel if stocks fell 35% and your $650,000 turned into $475,000? If that sits okay with you, you probably have the right stock-bond mix. If not, there’s good news: Today’s levitated market offers the chance to panic and sell at handsome prices.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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