Risk Tolerance Hasn't Sunk You As A New Investor - Now What?

by: Robert Jacobson

Summary

A 1,700 point drop in 4 days - how is your risk tolerance holding up?

Dividend Aristocrats, Contenders and Challengers help cushion the fall in the long term.

For new investors who haven't lived through corrections and bear markets, don't just dive in now that we've hit a correction.

So you survived a 1,700 point drop in 4 days and aren't looking to sell out of the market. While it may be difficult to suffer these steep short drops, this may only give you a partial idea of your risk tolerance. I would suggest from my experience that if you're new to investing, you won't really get a full picture of your risk tolerance until the length of a down market stretches over months rather than days.

However, if you've made it through the past three days in the market, you have some idea of your ability to tolerate the risk and might consider what your next steps should be.

My recommendations for new stock market investors, which I have listed in comments on Wednesday, 8/19, (just a matter of luck what happened the next three days as I don't even own a crystal ball):

  1. Try not to lie to yourself about your risk tolerance (but you may not be able to help it when you're basing your answer on a theoretical question and you don't have real money at risk).
  2. Start to invest in the stock market slowly with large cap Dividend Aristocrats, Contenders and Challengers. Also, just dip your toe or foot in. Slow and steady wins the race.
  3. Wait for a down period that will hopefully include some 1%-2% down days in order to determine how you "feel" about it before you start putting the rest of your leg in.
  4. Know what your investing timeline is for the earliest you might need access to any of your stock investment corpus.
  5. ALWAYS keep cash available that will last you at least 3-6 months (another decision that will require you to measure your risk tolerance) before committing any money to the stock market.
  6. Always have a shopping list available with the stocks you would want to buy at lower prices.
  7. You must be able to SWAN (Sleep Well At Night) as a measure of your risk tolerance. The further away the date you might need access to your investment corpus (and in my estimation this needs to be at least 5-10 years and longer), the better your ability to SWAN should be, particularly if you've followed step 5.

In my previous comments, I've always suggested having a shopping list of stocks you would be looking to own at lower prices, many of which should be coming from step 2 above. Now I suggest you take out that shopping list and start reviewing it carefully to see what you might want to buy and at what price. Don't jump in too deep, too fast though. No one (and I mean NO ONE) really knows how far down the market might go from here. The DJIA has made it to correction territory (>10% down), but the drop may or may not be over. We could be headed for a total market drop of 15-20% down or more, and then again, maybe this is it. You need to plan for either possibility.

Since where the market is heading is unknown, my suggestion would be to buy no more than 25% of what you've set aside for stock purchases in any one day. For those who have more investing experience, you may look to sell (cash secured) puts on an additional 25% at a strike price about 2-3 months out at 90%-95% of the current price since you don't know how long this down market will last. These must be stocks you want to own for the long term (see step 2 above again). You just want to own them at lower prices. In the meantime, you can take the income from these puts and pocket it. If you wind up having to buy a stock under the put option, you're happy because you got the stock you wanted at a price you were willing to pay plus someone paid you to buy it besides. This will still leave you with half your powder dry. If the correction continues, you may pick up an additional 25% of your stock from your put transaction with an effective basis that is lower by about 5%-10% from the current price plus the premium you received on the sale of the put. It is very important to remember that these need to be cash secured puts. I never recommend selling naked puts. That stretches even my own risk tolerance.

High volatility in a short period of time, particularly after a long period of minimal volatility, should elicit some caution, especially for a beginning investor. What is key is to have a plan that leaves you some flexibility. Don't just rush in with both feet because we finally hit the "correction" level after such a long period of time. Corrections can bounce back up to new highs and they can also fall to bear markets. Have a plan that prepares you for either. Also, remember that you are buying individual stocks and not the market so what you're buying may already be in a bear market. Investing is a marathon that requires a plan, not a sprint where you go all out as quickly as possible.

Keep Investing!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.