In his latest column on his Magic Formula Investing web site, Joel Greenblatt says it’s critical for investors to know what level of short-term losses they’ll be able to take before they start investing — lest they be scared out of the market at just the wrong time.
“An investment strategy where 100% of your assets are invested in the stock market (even with no leverage/margin account, etc) can result in a drop of 40% or more in your net worth in any particular year,” Greenblatt writes. “That’s so important to know (and plan for!). If you can’t live with a drop of that size, you can’t put all your money in the market. You’ll likely panic out or be forced to sell at exactly the wrong time.”
Greenblatt says he thinks the stock market is a great place to make money over the long haul, but he adds that “few people should put ALL their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.”
The key, he says, is assessing your risk tolerance before you invest, setting an allocation target, and sticking to it.
Then, he says, “hopefully you will no longer be tempted to sell all your stocks, put on your feety pajamas and roll up into a little ball” during short-term downturns. And, he adds, think long term. “Think in terms of 5 years, 10 years and longer,” he says. “Do your planning and asset allocation ahead of time. Choose a portion of your assets to invest in the stock market — and stick with it! Yes, the bad times will come, but over the truly long term, the good times will win out.”