Something finally happened in the stock market. What did you do?

It’s been a boring year in the stock market. If you bought Vanguard’s S&P 500 ETF on October 16, 2017, and held it until this last Friday, you would have earned a mere 10% in price appreciation, and a mere 2-4% in dividends (I can’t be bothered to look up the exact historical dividend yield at the moment). If you assume 2% inflation (and no, I don’t know why people assume 2% inflation), you’ve earned “about” 10% in real returns on your investment over the last 12 months. That’s a little bit above the historical average, and a lot below truly breakout years like 1933, 1954, or 2013.

But it’s been an interesting week in the stock market! So let’s talk about it.

All of this has happened before and will happen again

The same Vanguard S&P 500 ETF has lost 3.9% of its value this week (and 5.6% of its value since September 20). Some people get upset by price swings like this, but I have exactly the opposite view: price volatility is absolutely essential, not for any economic or financial purpose, but rather as an opportunity to learn something about your own reactions to price volatility.

Let’s be clear about one thing up front: most Americans have virtually no assets invested in markets of any kind. The price movements of the stock market are of concern to a small number of people beginning with the upper middle class and stretching all the way up to the oligarchs, and matter not at all to workers who experience, if anything, glee when their boss’s savings are wiped out.

Having said that, among the sliver of people with assets invested in the stock market, it’s easy to identify at least three very different reactions to price movements like this week’s:

• Total indifference. My partner participates in a workplace retirement savings plan, which is invested entirely in the Vanguard LifeStrategy Growth fund (the same fund my solo 401(k) is invested in). If her payroll cycle happens to coincide with a market downturn, she buys the dip, and if it coincides with an all-time high, she buys the peak.
• Greedy buying. I don’t know what path the price of the stock market will carve over the next 30 years, but I have a high degree of confidence that, with dividends reinvested, a stock market investment today will be worth between 5 and 6 times more 30 years from now. This is not a one-year prediction: a year ago, I would have been off by a full 50% (the stock market returned twice my estimated 6%). In any case, for long-term investors dips are obviously better times to buy than peaks, so one thing you might do when prices fall is use the opportunity to buy stocks you intend to hold for the long term.
• Panic selling. The only real mistake you can make when stock prices fall “dramatically” (a 5.6% decrease in a month is not, in any objective sense, dramatic), is to sell your stocks in a panic. The mistake is not selling your stocks — the mistake is selling them in a panic. The price of your stocks will fall 50% or more at least once in your lifetime. If you can’t handle a 50% or more fall in the price of your stocks, you own too many stocks, and are right to sell them. But you’re wrong to sell them in a panic.

A modest proposal for finding out what your “risk tolerance” really is

It’s standard for investment advisors, whether you’re talking about the sales teams employed by the big banks, fee-only fiduciaries, or roboadvisors like Betterment, to pose a series of standardized questions to identify your “risk tolerance,” so they can recommend an asset allocation. I’m sure a lot of work goes into formulating and processing those questionnaires.

But they all suffer from the same problem: they capture your “risk tolerance” at a particular moment in time. If stocks have been sailing smoothly higher, I can bet your “risk tolerance” will be pretty high. After a 50% drop in the stock market, I’m certain your “risk tolerance” will likewise be in the doldrums.

Thinking about this problem led me to a modest proposal for a way to assess the amount of stocks a person should actually hold: the investment attention journal. For a period, even a period as short as a week, carry around a pad and jot down every single time you think or do anything about any of your investments. How many times a day do you check stock prices? How many times a week do you buy or sell your investments? How many times a month do you reallocate your investments?

If at the end of a week, or a month, or a year, you have a blank page in front of you, you’ve shown yourself perfectly invulnerable to stock market movements, and might want to invest even more of your portfolio into volatile assets (which you’ll never check the value of).

If at the end of a day, or a week, or a month, you have a page full of timestamps showing how meticulously you track the price of all your assets, you might be too heavily invested in assets that are too volatile.

Sell down (or buy up) to the sleeping point

There’s a cliche in the asset allocation field that the right place to invest your assets is the “sleeping point:” where what happens to your investments isn’t keeping you up at night. The cliche usually goes, “sell down to the sleeping point.” But I’m so neutral on the question that I’m willing to entertain the flip side: there are people who are sleeping too well, and need to scale up their exposure to volatile investments!

In other words, your “risk tolerance” is not, or should not be, how you happen to feel about the stock market at a particular moment in time. It’s how you consistently, reliably, and verifiably react to movements in actual market prices.