Dealing with Fear of Investing

In recent weeks I have had conversations with some people who acknowledge that their investment strategy is too conservative given their age and investment time horizon. One of the main reasons these people cite for their overly conservative portfolios is a fear of losing their hard earned cash. Consequently, these individuals invest their savings in CDs or bond funds, and shy away from the stock market.

Let me begin by saying that I understand and accept risk aversion as a primary driver of investment strategy. In fact, no one should make any investment decision if that investment strategy will lead to them not being able to sleep at night. However, in the long run, what might seem like the "safe bet" will almost inevitably turn into a money losing proposition, given the stock market's propensity to outperform safer investments such as CDs or bonds.

If you share this very low tolerance for risk, but still feel that you are making a long term strategic error in staying out of the stock market, I propose the following strategy for dealing with the problem:

1. Risk Aversion is Legitimate - accept that you are uncomfortable with a large amount of risk. Do not try to over compensate for your risk aversion by buying emerging market penny stocks. Know who you are and what you are comfortable with, but try to gradually increase your level of comfort with the market.

You can do this by educating yourself on the various investment options open to you; by gaining a better understanding of how the stock market works; and in general by having a better sense of the economic forces at play. You may discover that much of your risk aversion is based on incorrect assumptions or even on a simple fear of the unknown.

2. Take Small Positions & Increase Them Over Time - one way to deal with your risk aversion is to slowly tip-toe into the market. Don't dump 40% of your investment portfolio into the market over night, go slow. Perhaps you will be comfortable with initially investing 5% of your assets in the stock market? Do that, wait six months and then decide if you are comfortable with moving a little more of your assets into the market. Taking this gradual approach may also protect you from sudden changes in market direction just as you enter the market.

3. Diversify - one of the best tools for reducing investment risk is diversification. Investing in a single stock, or a single industry sector is a risky proposition. However, investing in a large number of stocks diversified across multiple industries and (hopefully) multiple international markets is less risky. While the stock market inevitably experiences strong price fluctuations, the more diversified you are the less dramatic those fluctuations tend to be. The simplest and most cost effective way that I know of to achieve adequate diversification is to buy a broad based index fund such as Vanguard's Total Market Index Fund (VTSMX).

4. Check Your Investments Once a Quarter - if you are very risk averse, the worst thing you can do to your peace of mind is to track your investment performance on a daily basis. Remember, you are investing for the long term. Who cares what the stock market did today? Who cares if your mutual fund dropped 5% this week? All you should care about is how your portfolio will perform in the long run. Think years, not months. With that in mind, do yourself a favor: turn off CNBC, don't check the stock quotes and don't work yourself into hysteria. Check your investments once a quarter, and do so only to make sure that your mutual funds are performing well enough compared to their benchmarks.

5. Make a Plan to Limit Your Risk - if you are very sensitive to risk but still want to participate in the stock market, set your risk limits in advance. For example, decide that if your mutual fund loses more than 10% of your original investment you will sell it. That way you know that your risk is probably limited to losing about 10% of your money. That would sting, but it wouldn't be the end of the world. If you are investing for the long haul, that is probably not the wisest of strategies - I would just hold onto my diversified investments even in a down market - but if this type of risk limiting strategy helps you be more comfortable with the stock market, go for it.

Let me end this post by admitting to having a personal history as a fearful investor. I am now cured, pretty much due to the strategies I outlined above. After having endured the worst that the stock market had to offer during the darkest days of the Dotcom Bubble, I know I can pretty much handle any bear market without falling to pieces. However, I won't pretend that that was a fun ride...