Do the markets make you nervous? Yes, there are good reasons for the rise in stock prices. The world economy is growing. Corporate profits are healthy. Interest rates remain low and inflation tame.
Still, many of us share a sense of unease about investor optimism. Stocks and bonds are at their highest average valuations since 1900, calculates Goldman Sachs. The price of bitcoin is up more than 1,000 percent since the beginning of the year. U.S. credit market debt is more than 350 percent of gross domestic product, far above the 200 percent range that set in the 1980s (which is well above the 130 percent to 170 percent to range of the late 19th and early 20th century).
Those debt market figures come from John Maudlin, the financial writer and head of the investment advisory firm Millennium Wave Advisors. Maudlin is clearly on the nervous side about the elevated level of the market. But he makes an important point about the lure of finding a way to enjoy the upside of markets while limiting capital losses when the plunge comes: It doesn’t work.
Among the more infamous volatility-linked products that failed to live up to this promise was portfolio insurance in 1987. Thirty years later, Maudlin said he worries that popular hedging contracts linked to the Volatility Index (VIX) are pursuing the same goal as portfolio insurance.
Even with the benefit of hindsight it’s hard to say what exactly triggers a change in investor sentiment. Instead, I would focus on gauging your financial “capacity” to take risk. Rick capacity is the jargon term for an understanding of how much risk your finances can realistically absorb.
The starting place for understanding risk capacity is your income and your career. How stable and reliable is your income? Let’s say your income is relatively secure. In that case, you can handle more market risk. Alternatively, if your earnings vary significantly during the year and the specter of unemployment a constant worry, you should embrace a more conservative portfolio. (Think self-employment and contract labor.) It will help offset your income volatility. Other critical variables to consider are the strength of family ties and the amount socked away in savings accounts. Critical to your risk capacity calculus is your financial obligations, say, the mortgage and caring for aging parents.
The risk capacity calculation is more art than science. Still, the bigger your margin of financial safety the more risk you can embrace, and vice versa.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.