Most investors have received their third-quarter account statement by now and the news wasn't good. August and September were tough months for stocks and low-quality bonds and most portfolios showed losses.
Looking at the year over all, investors have had everything thrown at them – plunging oil prices, the crisis in Greece, slowing growth in China, lower interest rates and lots of volatility. Think of it as a cheap practice run for the much tougher periods we'll inevitably face in the years ahead. I say cheap because the third-quarter decline was smaller in magnitude than the dozen positive quarters we've had since the bull market began in 2009, and with the market gains so far in the fourth quarter, diversified portfolios are now well up for the year.
There's much to be learned from such a bizarre year, which makes it an ideal time to do a self-assessment.
Before looking in the mirror, you have to understand some key principles that underpin any risk assessment.
First off, stock markets are highly cyclical. Long-term returns come with many ups and downs, a few extreme ups and downs and almost no periods of "steady as she goes."
Second, to earn an annualized return of 5 per cent to 7 per cent in a low (no) interest rate environment, your portfolio needs to be made up mostly of stocks, with perhaps some aggressive fixed income or alternative strategies blended in.
Third, you can't get in and out of the market and expect to hit your return target (that is, sell high and buy lower).
Timing the market over an extended period is virtually impossible for two reasons: You have to get it right when you sell, and follow that up by making the hardest decision in investing, which is determining when to get back in.
And finally, for an asset mix to be appropriate, it needs to be one you can stick to during all phases of the market cycle. Bailing out of a strategy when times are tough is the most reliable way to crush a portfolio's long-term returns.
It all adds up to this: If you're seeking a return well above inflation, you must be willing to live through years when your portfolio is down by 10 per cent to 20 per cent, with 10 per cent being a given and 15 per cent to 20 per cent a possibility.
Your self-assessment can be boiled down to one key question: When markets were bouncing downward in August, were you licking your chops and buying stocks on dips, or were you spooked by the volatility and wondering whether 2015 was going to be another 2008?
In an ideal world, weak markets should be celebrated by younger investors who are accumulating assets. "On sale" signs are a good thing.
But if you had your finger hovering over the "sell" button in August, then it's unlikely you'll be able to hang in when stocks go through an extended and more severe pullback. If you can't live with short-term losses, then you should consider taking one of following steps.
The first thing to explore is whether it's possible to firm up your resolve by finding a trusted adviser or friend to lean on. I'd suggest talking openly with this person about what the next bear market will be like, and how you'll deal with it.
Failing that, you'll need to reduce the risk in your portfolio and begin to save more and/or set a lower target for your spending in retirement. Neither option is satisfactory, but both fit with a more stable portfolio.
If you're retired and drawing an income from your portfolio, risk management is more difficult. You don't have the same capacity to absorb market dips and yet, with bond yields where they are, you have no choice but to own a healthy dose of stocks. Even if you're not seeking as high a return as the accumulators, you still need to be prepared for down periods.
Investors have been given a gift. A test run like 2015 doesn't come along very often and it shouldn't be wasted. If you don't think you can handle three or four quarterly statements like the one you just received, now is the time to make changes. One thing is for sure – you don't want to be doing it in a real bear market.
Tom Bradley is president of Steadyhand Investment Funds Inc.