How Big Is My Cushion?
That’s the primary question anyone nervous about the recent drop in the stock market should ask him or herself.
Rather than dwell upon 1,100-point drops in the Dow, think about how much you have set aside in conservative bonds and cash. This is the fixed income side of your portfolio, or what I like to call the “cushion”.
The cushion is meant to carry you through the tough times. Every client I work with has a cushion designed according to their particular circumstances.
The decline in stock prices over the past week makes everyone nervous, including me. Watching your portfolio go up in value is much more fun than watching it fall, but you can’t have one without the other.
We know there will be periods like these when stock prices fall, but we also know that historically stock prices rise about two thirds of the time. To reap the gains when prices are rising, one has to be willing to accept some exposure to the risk of falling prices since we can’t predict when the stock booms or busts will occur, no matter what anyone on CNBC says.
The big question is how much exposure to the risk of stocks there should be in your case.
That’s what I view as one of my primary tasks as a financial planner and investment advisor — managing the level of investment risk based on individual circumstances.
When I begin work with any client, the first thing I try to assess is how large the fixed income side of the portfolio should be. Typically, I will recommend keeping about 40 to 60 percent in fixed income — most of it in conservative short- and intermediate-term bonds with a little bit of cash mixed in.
Some clients may have a little more or less in fixed income, depending upon their circumstances.
While the S&P 500 stock market index fell 4.1% on February 5, a client with a 60-percent stock, 40-percent fixed income allocation probably saw their portfolio drop about 2.5%. That’s because of the cushion.
When the stock market is taking a dive, ask yourself how long the bonds and cash you own would last based on your current spending patterns. If it would last five years or more, then the wisest thing to do right now is to give stocks time to recover. But if you will need to pull from the stock side of the portfolio over the next five years, then we should talk.
For additional thoughts on the recent stock market drop, let me suggest an article published by Jonathan Clements, a former Wall Street Journal personal finance columnist.
Reading Jonathan’s column back in the late 1990s and early 2000s is one of the factors that led me to become a financial planner. You will never go wrong reading what he writes during times like these.