What’s your measurement?

“Our worries – when it comes to money – are about psychology as much as economics, the soul as much as the bank balance.”
John Armstrong, How to Worry Less About Money

2012 and 2013 were such good years for US stock investors that some of us can begin to forget what large losses feel like.

In recent conversations with physician investors, especially younger ones, I’ve been posing the question, “How would you feel about having your portfolio decline similarly to what was experienced in 2007-2008?”

At first, I use a generalized question as the example. “How would you react if your portfolio dropped as much as it did in 2008?” No numbers, no dollars, just a question of general recollection. The younger the physician, usually the less emotional-laden the answer, something like, “Hmmm…I wouldn’t like it, but we’d be ok.”

Next, I offer a percentage. “Your portfolio is primarily made up of stocks today. How would you react if your stock portfolio declined by 35%?” This tends to elicit a stronger response. “Wow! That would be tough to take. I’m not sure how I’d react.”

Finally, I ask the same question, but use dollars as the measure. If they’ve been doing a good job of saving and investing over the past five years, it’s quite possible a young doctor in their mid-40’s has accumulated over $500,000. Let’s say they have $600,000 between their retirement plan and some after-tax accounts. “How would you react if your $600,000 declined to $390,000?” A recent answer was, “I’d stop opening my mail!”

Obviously, the answer to each question references exactly the same decline just described in different units of measure. For most of us, however, the more concrete the measurement, the more real it becomes in our mind. So, describing the loss in actual dollars, gets us out of both generalized terms (e.g., “big loss”), and theoretical terms (e.g., “down 35%”).

After a five-year market recovery, we can be just far enough away to forget what significant dollar losses feel like. As you consider your current portfolio and the allocation of that portfolio to stocks, try this exercise to see how a big dollar loss might feel to you today. Take the actual dollar amount you have in stocks in all of your investment and retirement accounts combined and imagine that value declining by 35% of the over the course of 12 months. Write these three numbers down in dollars so you can see each one:

1. Current value of stock portfolio.
2. 35% of current value of stock portfolio (1 multiplied by 0.35)
3. Remaining value (1 minus 2).

If you have $500,000 in stocks, your three numbers would be:

1. $500,000
2. $175,000
3. $325,000

Now ask yourself, honestly, if you could stay fully invested in your current portfolio faced with those numbers. It’s just fine if the answer is, “No.” With stock market indices at all-time highs in the United States, now may be a very reasonable, even an opportune, time to rebalance to a lower allocation in stocks and establish a new long-term investment policy.

While we, at Foster Group, still think stocks have significantly higher expected returns over longer periods than bonds or cash, most investors do not need 100% of their portfolio invested in stocks to meet their long-term financial goals. The critical actions for investors come in selecting a reasonable portfolio allocation of stocks and bonds and most importantly, being able to hold this portfolio throughout all kinds of market conditions. Measuring your tolerance for potential investment declines in dollars is one simple exercise to help confirm whether your current portfolio is still a reasonable one for you both psychologically and economically.