Investing is serious business. An investor is wise to be concerned about losses in his portfolio. How you think about and manage this risk will play a significant role in your financial success.
One trap I’ve seen investors fall into is what I call The Hibernation Trap. This occurs when an individual does not fully understand how much risk he is taking with his portfolio and as a result feels compelled to bail-out of the market when performance gets choppy. Consider the following example of a seasoned professional business man that allows his emotions to encourage knee-jerk reactions.
Like most investors, Steve has no problem watching the value of his investment account rise when the going is good. When the inevitable does happen, however, and the stock market takes a breather, Steve pulls his money out of equity funds and moves to a conservative posture holding a mix of cash and fixed income instruments. There are two problems in doing so. First, Steve needs to get out at the right time and doing so is difficult in its own right. Let’s assume Steve’s gut feeling turns out to be correct and the market does decline in the ensuing weeks. Feeling good about himself, he confidently looks at his account earning money market interest while his friends’ accounts are being depleted. Steve needs to be careful not to quit his day job too soon and head for that high six-figure salary on Wall Street, however. His work is only half complete.
Steve now has to make the difficult decision of when to jump back into the market. This is no small task. Missing the market low and entering just a week or two too late can prove devastating to long-term results. Missing only the best performing month each year can make the return of an aggressive growth mutual fund look more like a low volatility balanced fund. Financial markets tend to rally in bunches. Missing-out on a significant rally, because your crystal ball failed to notify you when to reenter the market will make it more difficult for you to reach your long-term goals.
Becoming fully aware of the risk you are taking with your portfolio will help you to resist the temptation to pull your money and go into hibernation. Understanding the expected risk you are taking and following a long-term disciplined approach will not only reduce your stress level, but it will also keep you positioned in a manner that will maximize your chances of meeting your long-term goals.
This article is for educational purposes only and is not a personal recomendation of any strategy or product. You should not make any changes to your financial situation based only on this article. It is advised that you consult a qualified advisor and tax professional to evaluate your situation before making any changes to your finances.