Should You Freak Out If the Market Melts Down?
It seems that every time the stock market hits a new high these days—or retreats from one—we hear rumblings of a potential crash. In an interview last week after the Standard & Poor’s 500 hit yet another peak, Yale professor Robert Shiller noted that stock valuations were near levels that preceded meltdowns in the past and thus were “a cause for concern.” But if you’re investing for retirement, should the prospect of a bear market give you a serious case of the jitters?
I don’t want to downplay the havoc that a market meltdown can trigger. It can wreak havoc with the economy. And if you’re on the verge of retirement and have a big portion of your savings in stocks, a setback on the order of the 2007-2009 50%+ drop in stock prices could force you to sharply scale back your post-career lifestyle or stay on the job longer than you want. But if retirement is many years away, even a severe downturn isn’t necessarily a big deal. It could even work to your advantage, as the stocks you scoop up at at a market bottom can earn the highest long-term return.
Regardless of what stage of retirement planning you’re in—just starting out, mid-career, ready to retire or already retired—there are two important things you need to know about market crashes. One is that there’s no avoiding them. Bear markets have been around as long as we’ve had stock markets. Since World War II alone, we’ve had eight major downturns averaging nearly 39% and lasting an average of 19 months. Big, scary dives in stock prices are a normal part of the investing landscape that will always be with us. Rather than trembling in fear of their onset, smart investors learn how to live with the certainty that sooner or later stock prices will collapse.
The second thing you need to know is that, far more important than the meltdown itself, is how you handle it. And that largely depends on how well you prepare ahead of the crash. Once a major correction is really underway, there’s not a whole lot you can do to stave off damage to your portfolio; indeed, scrambling to mitigate the damage may make matters worse. Nor can you depend on some gut instinct or trusty technical indicator to get you out of the market just before things fall apart. In retrospect, it’s always easy to see when the meltdown started. But in real time, it’s impossible to tell in the early stages of a bear market whether it’s The Big One or is just another false alarm.
So what should you do to prepare in advance to prepare for an inevitable market setback, while also staying positioned to share in the gains if the market continues to rise rather than drop (which ends up being the case most of the time)?
Start by getting a handle on your true appetite for risk, specifically how much of a drop in the value of your savings you can stand before you start unloading stocks in a panic. The Investor Questionnaire in RDR’s Retirement Toolbox can help you make this assessment. As you do this risk evaluation, keep in mind that investors have a tendency to underestimate how much risk they’re taking when stock prices are rising and overestimate the risks they’re taking after prices have plummeted. Be careful not to get swept up in irrational exuberance when the market’s on a tear, and avoid becoming overly pessimistic in the wake of a crash.
Next, make sure your portfolio jibes both with the level of risk you’re willing to accept, and that your mix of stocks and bonds makes sense given your investment goals. Reconciling these two aims can be tricky. If you’re risk-averse by nature, you may feel much better emotionally by hunkering down almost exclusively in bonds or cash. But such a low-risk portfolio may not give you the returns you’ll need to build an adequate nest egg or allow you to draw sufficient income from your savings once you’ve retired.
So you need to balance your emotional needs with your financial needs. Your aim is to end up with a portfolio that has enough exposure to stocks so that you have a decent shot at earning a reasonable rate of return, but not so stock-heavy that you’ll be reaching for the Maalox every time some pundit prophesies doom. The Retirement Income Calculator in RDR’s Retirement Toolbox can help you gauge whether the mix of stocks and bonds you’re contemplating can give you a reasonable shot at achieving your retirement goals.
Once you’ve done that, you should largely stick to your mix of stocks and bonds regardless of what’s going on in the market or how your portfolio is doing at any particular moment. That can be tough. You can always come up with reasons to justify straying from your investing principles or strategy “just this once.”
Resist that temptation. Often, what seems like a good move in the moment isn’t wise for the long run. In the spirit of full disclosure, I recently wrote a column explaining how I abandoned my investing principles years ago by selling shares of Warren Buffett’s Berkshire Hathaway company only seven months after buying them. As a result of that lapse, I missed out on a near $400,000 gain on that stock. Ouch.
Hanging on every twist and turn of the market is no way to live, especially in retirement. So instead, learn to live with the fact that the market is flighty and the knowledge that every now and then it’s going to tumble. Just prepare ahead of time, so you can handle that volatility, financially and emotionally. (9/9/14)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com.