When to Dial Down Your Stock Market Exposure

If you have been following the stock market closely over the last month, then you might be giving yourself an ulcer. The S&P 500 index dropped almost 10 percent since its high in September, and it can be unsettling to see your net worth decrease every day. Every investor knows that the stock market is volatile. However, we have had such a great run over the last 5 years that some of us forgot how it feels to see a big stock market correction.

If you are investing for the long run, then a big stock market correction is actually a good thing. That's when you can pick up additional investments at bargain prices. But some of us are still a nervous wreck going through one, even when we know we will be better off staying the course over the long term.

The average investor is notoriously bad at timing the market, so you should never just sell all your stock investments at once. But many of us want to scale back our stock market exposure as we get closer to retirement and have more assets to protect. Here are some times when you should dial down your stock market exposure.

Investment timeline. If you need to use a significant portion of your investment in the next five years, then you should save that in a more stable investment. Making a down payment for a house, paying for college for your children and funding your near-term retirement expenses are all things that require a lot of cash. Investing those funds in the stock market is a bad idea. For example, let's say you want to buy a house within the next two years and need to put down $60,000 to avoid private mortgage insurance. It might be tempting to invest that in the stock market because the recent gains have been great. But what happens if the stock market drops 20 percent just as you find the perfect house? Then you'll have to sell at a loss and you won't have enough to avoid buying the insurance. Or you'll have to pass on the dream house and wait until the stock market recovers. It's better to invest in a CD or something safer if you will need the money in the next few years.

Retiring soon. Retirement is a big transition. You won't have as much income and you'll need to start drawing down your nest egg. If you're retiring soon, you should work with a financial advisor to figure out the appropriate mix of investments. Most of us have a lot of stock when we're working because we keep buying to take advantage of dollar-cost averaging. When you're retired, you need to be more conservative and protect yourself against a big stock market correction. If you're retiring in the next few years, you probably need to decrease your stock investments and increase your fixed income investments.

Haven't rebalanced lately. The U.S. stock market has risen much faster than other asset classes, and your stock allocation could be much higher than you're comfortable with. When your stock allocation is higher than your target asset allocation, stock market volatility will cause a bigger swing in your net worth. If you haven't rebalanced in the last few years, then it's time to rebalance your portfolio and reduce the stock exposure down to your target asset allocation.

Reassess your risk tolerance. Most of us become more risk averse as we get older and more well off. When I was 24, I didn't mind investing all my money in the stock market. Even if I lost all my money, it wouldn't be the end of the world. I probably had about $20,000 in the stock market when I was 24. Now, I'm more established and my risk tolerance has changed. It would be devastating to lose 50 percent of my investment. I invest a little more conservatively now and hold more bonds. If you haven't assessed your risk tolerance in the last five years, then it's time to evaluate your asset allocation.

If you are losing sleep over the stock market drop, then that means you're not investing appropriately. If you are not comfortable with your asset allocation it could drive you to sabotage your own investments. During the financial crisis in 2007 and 2008, many investors sold when the stock market was down and missed out on the subsequent recovery. You need to figure out an asset allocation that you are comfortable with and stick with it though the bear markets. The key is to keep investing and take advantage of dollar-cost averaging while you're young. A good financial advisor is an invaluable asset. Your financial advisor can help you figure out your asset allocation and offer moral support as you hold fast through the stormy markets.

Joe Udo is a stay at home dad who blogs at Retire by 40.