The crashes of the future
If the stock market were to crash 20 years down the road, how much damage could this do to my investments?
NEW YORK (CNNMoney.com) - I'm 24 and I've just started a Roth IRA account that I plan to max out every year. I also have about $15,000 in a money-market account for emergencies that I plan to add $50 to every month. If the stock market were to crash 20 years down the road, how much damage could this do to my accounts and is there anyway to protect my investments?
-- Mike Stearns, Maple Grove, Minn.
Hey, I'm all for thinking ahead and having contingency plans in case things go wrong. But worrying about a market crash that may or may not happen 20 years from now strikes me as a waste of psychic and emotional energy.
I mean, if you're looking for financial issues to fret over, there are so many more possibilities you're much more likely to have to deal with over the next decade -- getting a good job, making sure your career stays on track, starting a family, assuring that you'll be able to save enough in 401(k)s, IRAs and the like for retirement. These are the sorts of issues you should be focusing your attention on, not market setbacks way in the future.
Future bear markets are likely
Fact is, even before you hit your 44th birthday, you're likely to see several bear markets when the overall stock market takes a significant dive. All of them aren't likely to be as severe as the last bear market when the Standard & Poor's 500 index tumbled by almost 50 percent between March, 2000 and October, 2002 (and, nearly six years later, has yet to regain its earlier peak). But I would certainly expect to see declines in excess of 20 percent where it takes stock prices a few years to recover.
And you know what? You shouldn't obsess over these setbacks either. That's part of investing. The higher risk of short-term volatility is why stocks have historically delivered much higher returns than less jumpy assets like bonds, CDs and money-market funds. Over the past eight decades, stock have generated an annualized return of just over 10 percent compared with a bit more than 5 percent for bonds and less than 4 percent for cash investments, which would include money-market funds and the like.
I'm not saying a repeat is a given in the years ahead, but I'd certainly expect stocks to deliver higher returns than bonds and cash, even if the margin of victory shrinks somewhat as many experts expect. To get those higher returns, however, you've got to stick with stocks during some turbulent times.
Of course, it would be great if you could invest in stocks during the up periods, then jump into bonds or money funds just before stocks take a dive, and then get back in stocks again for the next ride up.
But nobody's timing is that good. So smart investors do the next best thing: they hedge their bets by spreading their money around.
Even out the possible bumps
If you're investing money you may need to tap at any time -- like your emergency fund -- then you keep it in a money-market account, money-market fund, a CD, savings account or very short-term bond fund. You won't earn a very high return, but your principal isn't at risk.
If you're investing money you won't need for a longer period of time, then you can afford to put more of your stash in stocks. You're not worried so much about short-term setbacks; you're more interested in racking up long-term gains. This should certainly be the case for the money you're investing in your Roth IRA now, as well as money you'll contribute to your 401(k) when you get a job at a company that offers that option.
For guidance on how to divvy up your investing stash between stocks, bonds and cash, I suggest you check out our Asset Allocator. And while you're at it, it wouldn't hurt to read our MONEY 101 lesson on Asset Allocation.
Your mix will change
One final thing: as you get older, you will indeed want to start paring back your exposure to stocks. But while 44 might seem older to a Twentysomething youngster like yourself, it's not very old when you consider that most 65-year-olds today will live into their 80s, and many will make well into their 90s (and an increasing percentage will crack the century mark).
When I say older in this context, I mean when you're in your late 50s and 60's. And even then, you'll still have a whole lotta investing ahead of you, which means you'll still want to keep a good portion of your portfolio in stocks. For more on how the asset mix in your Roth IRA and other retirement accounts might change as you age, check out A plan for every stage, which ran as part of MONEY's Dream Retirement special report.
So lighten up, man. This is the time in your life when you can afford to take some prudent risks in your Roth IRA and other long-term investments. When you look at your Roth account balance 20 years from now, you'll be glad you did.