Buy Stocks and Retire

You've lost a bundle, but being overly cautious is no way to get it back.

Maybe this situation isn't too hard for some of you to imagine. You've worked hard your entire adult life and finally amassed $1 million, and then a bear market with few safe havens took down the value of your portfolio by 40%. Retirement looms in five years, either by choice or by mandate, and you're terrified of feeding a stock market that just ate your future.

What to do? The answer: Buy more stocks.

So says Forbes.com Investor Team member Sacha Millstone, a decorated adviser with Raymond James. Millstone points out that one of the biggest mistakes would-be retirees make is playing it too safe after taking a spill. While it might seem that going back into the market, guns roaring, is doing little more than doubling down on a bad bet, she says often people play it too safe, with too much money in bonds.

"After a market drop of 40%-plus, it is not the time to get conservative," Millstone says.

Jeremy Siegel, the widely quoted University of Pennsylvania finance professor and author of Stocks for the Long Run, wrote in early October that domestic stocks haven't been this affordable in 30 years. And back then, Siegel writes, "the U.S. economy was in far worse shape than today."

James Peterson, vice president of qualitative analysis at Charles Schwab Corp., projects that with a 20-year time horizon, large-cap stocks are estimated to return 8.2% annually. Small- and mid-cap stocks beat that handily, with an estimated return of 9.8%.

Peterson comes to these conclusions for large-caps by calculating the equity risk premium--literally the attractiveness of large-caps versus risk-free bonds--over several decades past. With mid- and small-caps, Peterson uses the ERP as the starting point and then adjusts for the greater risk taken on by holding smaller firms. He notes, though, that such projections, being backward-facing, can create unreasonable expectations.

Bonds, Peterson notes, are expected to return 4% going forward. Kind of hard to get too excited.

Longtime investors might be disappointed in these returns. Analyzing results from 1970 through 2007, Peterson calculated annual compound returns of 11.1% for large-caps, 11.4% for mid/small-caps and 8.5% for bonds. But that time has passed.

Some defensive plays to compensate for an era of diminished returns include avoiding unnecessary fees and taxes. Also, if you have a financial plan and it didn't work, as per our hapless would-be retiree, it's time to revise it.

Forbes.com Investor Team member John Osbon notes that older investors can consider simply investing in Treasuries and pocketing $100,000 at the end of five years, "the no risk route," as he calls it. But that won't get you back to $1 million.

Randy Frederick, director of derivatives and trading at the Schwab Financial Center, says investors could consider staying in equities for three years. Then, if they're up, they can shift more into fixed income. "It is difficult to imagine that the equity market won't be at a higher level, at some point in time, within the next five years," he says.

How to Retire

Millstone: You should rebalance your account, and you probably should take another look at all of the investment options in the 401(k) in order to do so. Most plans have online resources to help you determine what your balance should be. These resources are generally based on your age and your answers to an online questionnaire.

I caution people not to be overly conservative when answering these questions. After a market drop of 40%-plus, it is not the time to get conservative. In fact, many plan participants who were diversified already may now find their bond allocation is too high--they may need to move some money out of bonds and into the stock asset classes.

If possible, now is a good time to talk with your financial adviser about your 401(k). A financial adviser may be able to give you needed perspective now. If long-term goals have not changed much, then neither should the asset allocation that was previously set.

Osbon: You have two investment choices: retire in five years with $700,000--the no-risk route--and live beneath your means, or high risk: invest mostly in stocks now with a shot at $150,000 or $500,000 and be content with either outcome. With only five years, your investment answer is more a function of what satisfies you than what to invest in. You can't make markets produce what they cannot.

Alternatively, you might get really lucky in the next five years. Let your minimum acceptable outcome drive your investment choice. The rest is gravy. And ... you could always keep working.

Frederick: It is difficult to imagine that the equity market won't be at a higher level, at some point in time, within the next five years. Clearly, it is lower now than it was five years ago, but it was much higher just a year ago. Though no one can accurately pick the bottom of the market, it is our belief that we are probably closer to the bottom than we are the top.

While no one can accurately pick the top of the market either, if it is higher in three years, at least you'll be in better shape than you are at the moment, at which point you can shift out of some of your equities and more into fixed income. It is surprising how quick these cycles change. Like many investors, I took a substantial hit to my 401(k) in 2001 and 2002, but by 2007 I got it all back.

Our advice at Schwab is that you should maintain a well-balanced, properly allocated portfolio, in all markets. As market cycles shift, be sure to reallocate due to excessive losses or gains in certain sectors. While everyone's situation and risk tolerance is different, a very simple rule of thumb is to have a fixed income allocation percentage that is approximately equal to your age.