Rethinking the risk of stocks

By Walter Updegrave, senior editor

(Money Magazine) -- Just when you thought it was safe to go back into the water again -- boom! -- the market started going haywire. After a 75% surge from a little more than a year ago, stocks have plunged 12% from the beginning of May through yesterday's close.

Unfortunately, recent research from Morningstar and Ibbotson Associates suggests that stocks are more prone to these sorts of convulsions than you may realize.

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

The reasons are somewhat technical but boil down to this: The traditional way of forecasting stock performance assumes that returns are bunched together in the proverbial bell curve. In reality, however, a curve tracing stock returns has "fat tails." That's quant talk meaning that even though most returns fall within a tight group, there are more extreme highs and lows than you find in a normal bell shape.

That, in turn, means more potential for the market to zoom -- but also more potential for big plunges.

How much more? Under the traditional view of stock volatility, there's about a 1% chance of the Standard & Poor's 500 index suffering a five-year loss of 40% or more. By contrast, Morningstar estimates those odds at 3% to 6%.

A little perspective here

Yes, those odds are a lot bigger than 1%, but they're still small. And let's not forget that we're dealing with projections, not guarantees. So it doesn't make sense to ditch equities.

Even so, you'd be wise to factor the possibility of more frequent steep drops into your investment strategy. That's especially true if you're in or nearing retirement, which is when major losses wreak the most damage because you have less time to recover.

One-third of longtime 401(k) participants still haven't made up the ground they lost during the last crash -- and that's despite making additional contributions.

Assess your stock stake

Begin by gauging whether, given your current stock stake, you could tolerate the loss if we see another blowup. A 60/40 stock/bond mix lost about 30% in the last downturn. If you would have trouble handling such a setback, you need to dial back your stock exposure.

Keeping a hefty cash reserve of, say, two years' worth of retirement expenses can also help, because your portfolio is likely to last longer if you can avoid selling into a crashing market.

Get guaranteed income

Next, give serious thought to putting some of your savings into an immediate annuity to generate income that will keep flowing even when the market dives.

Those steady payments will give you more flexibility in drawing from your portfolio and give it a better shot at recovering from market slumps, no matter what the next decade (or two, or three) dishes out.  To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed3.94%3.93%
15 yr fixed3.03%3.03%
5/1 ARM3.33%3.27%
30 yr refi4.02%3.99%
15 yr refi3.09%3.07%
Rate data provided
View rates in your area
Find personalized rates:
Index Last Change % Change
Dow 16,461.32 -153.49 -0.92%
Nasdaq 4,382.85 -36.63 -0.83%
S&P 500 1,927.11 -14.17 -0.73%
Treasuries 2.23 0.02 0.95%
Data as of 8:51pm ET
Company Price Change % Change
Bank of America Corp... 16.40 -0.20 -1.20%
Yahoo! Inc 42.00 1.82 4.53%
Apple Inc 102.99 0.52 0.51%
Facebook Inc 78.37 -0.32 -0.41%
Boston Scientific Co... 12.32 0.29 2.41%
Data as of 4:04pm ET


Domino's pizza used to suck. Now people like it and the stock is at a record high More

The midterm elections are around the corner, and the economy remains a top concern. With unemployment down and inflation low, why do people still feel the economy stinks? More

Uber canceled its free rides with hot girls promotion in Lyon, France before it ever launched. More

Startups focusing on "ag tech," or agricultural technology, are gaining the attention of farmers and investors More

Dressing up in crazy costumes, traveling the world, posing for photos -- and getting paid to do it. Here are journal entries from a day in the life of professional "cosplay" character, Linda Le. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.