“I don’t like putting my money in the stock market; it’s too risky.”
“Stupid stock market! My retirement account goes up and down but generally goes nowhere.”
These statements indicate a problem but it’s not with the stock market. The problem has to do with your risk management. We all have to be invested in the stock market; we have no choice. “What!? I have no choice?” That’s right. Here’s why.
Look at the typical retirement prospects awaiting average hard-working people.
- Your only source of retirement income is government, family or charitable help.
- You work your whole life.
- You create enough wealth and/or income to allow a higher standard of living in retirement— including other sources of income like a pension.
Okay, so you do have choice if working your whole life or choosing a standard of living supportable by Social Security is on your radar. However, if you want more for your retirement, you have to create wealth that will sustain you for decades of retired life.
To create wealth requires ownership—lots of ownership. Ownership is stocks (ownership in companies through the stock funds in your TSP, 401k, etc.), properties, or building your own successful business. Only ownership provides investment returns large enough to offset the negative effects of taxes and inflation and allow us to build enough wealth from our limited incomes. Ownership provides the necessary returns because ownership involves risks and risk pays. Safe and conservative savings plans do not provide returns high enough to offset taxes and inflation and build wealth.
“That’s the problem. Ownership involves risk and I hate risk.” Yeah, but risks are manageable. You manage risks every day: driving, exercising, walking across a street, your health, you name it. Life is a risk. Investing is no different; risks can be managed to your benefit. Here are four of the easier ways to manage stock market risks.
Take a long-term view. The shorter your investment horizon, the greater your risks. The longer your view, the lesser your risks. That’s why you have to attack stock investing as a long-term game plan. Hey, you’ll be a stock investor until you die so what’s the hurry? When measured in 10-year chunks, the worse U.S. stock market 10-year period was 1999-2008 when it was down 1.4% (SP500 index). “Seriously, only a whopping 1.4%!” Yep. Considering periods 15 years and greater, there has not been a negative stock market period.
Voila! Stock market risk eliminated by having a long-term game plan. But you can do better.
Average down. This is also known as dollar-cost-averaging. It’s a dirt-simple investment strategy. All you do is contribute to your stock fund investments (401k, TSP, IRAs, etc.) on a regular basis for a long time. Why? Because the stock market goes up and down by its nature over shorter periods (remember over long periods 15+ years it’s always up). As the stock market drops and your contributions continue religiously, you buy more shares (shares = ownership) of stock funds in your accounts.
Eventually the stock market will bounce off the bottom and go on to higher levels while you picked up beau-coup shares at bargain basement prices. Under this strategy, a down stock market is your friend—you’ll actually want the stock market to drop.
The name of the game is lots of ownership; not watching your account value. The person who retires with the most ownership shares wins! Your account value will take care of its self as a by-product.
Wasn’t the stock market dropping a fear for you earlier? A falling market was the risky part of investing. Now you’ll love falling markets and they can make you wealthy over time. In fact, the stock market has to drop for average investors to build wealth.
Kiss the fear of this risk good-bye.
Allocation. This is the percentages of your portfolio’s mix of stocks, bonds and cash…for the most part. As an illustration, 80% stock funds, 15% bond funds, 5% cash funds. All markets (stocks, bonds, cash) go up and down over the short term. Stocks are the most volatile (up and down by greater degrees), bonds next and cash last. Therefore, the more stocks you own, the more your portfolio value swings up and down. The more bonds and cash you have, the less your portfolio swings up or down.
Use allocation like a regulator to control the up and down movements in your portfolio values—in other words controlling your risk. Most times stocks, bonds and cash move in opposite directions from each other so bonds and cash act to tap down the volatility in a stock portfolio.
If you have a long time horizon before retirement, you want your account to have wide swings in value to take advantage of the principals discussed above.
If retirement is within 10 years, you start adjusting your portfolio allocation to reduce the chance your account value will drop too much as you get ready to use your wealth for retirement.
You now have a safety valve to control risk. Now don’t you feel powerful?
Rebalance. After discussing averaging down and allocation above, you now realize you structure your portfolio allocation to achieve an objective. Generally, your objective is either wide swings in your account value to maximize the effects of the averaging down strategy or preventing wide swings to protect your account value as your close in on your retirement years.
Whatever your chosen objective and allocation, it will get out of whack as markets move up and down over time. Be sure to re-balance your allocation every year to ensure your allocation maintains the objective you intended. Just the act of re-balancing to your original allocation forces you to sell the shares that are high so you can bulk-up the shares that are low. Buy-low, sell high. Bet you heard that before. Another risk lessened.
Add these all up and you have your risks understood and managed. Now, what are you scared of?