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| Chances of a market crash |
FEAR
Chance of a market crash in any given year, according to investors: 1 in 2.
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REAL DANGER
Likelihood of a crash, according to research by Vanguard: 1 in 50.
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WHAT TO DO
Diversify and hold down trading costs. Mediocre returns are the real threat to your financial goals.
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Source: Vanguard Center for Investment Research
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NEW YORK (MONEY Magazine) -
Nearly half of those surveyed in the MONEY/ICR poll said they were worried about the possibility of a market crash. And according to Vanguard's Center for Investment Research, investors think that there's a 51 percent chance that U.S. stocks will lose a third of their value in any given year.
Based on historical returns, Vanguard calculates that the real probability of that happening is about 2 percent.
Why this stunning mismatch between perception and reality? Because memories of the Nasdaq's 2000 crash are so vivid and painful that they color the way we look at current risks. That's what risk experts call "availability bias."
Add to that the alarmist bias mentioned earlier. If stocks can fall 10 percent, we think, why not 30 or 60 or 100 percent?
The good news is that the odds of such a calamity are extremely low. The bad news is that there's a bigger threat to your long-term goals lurking in the market. What is it? Mediocre returns that last for decades.
Why? Mainly because the fat stock returns so many of us got used to in the 1980s and 1990s reflected a giant mark-up in the price of stocks, as baby boomers got over their fear of them and started moving serious money into the markets. In 1982, stocks were collectively priced at eight times their annual earnings; by 2000 they were at 33 times earnings. (The P/E ratio stands today at about 22.)
But unless whole new demographic groups, like Asia's burgeoning middle class, suddenly start putting a lot of money into U.S. stocks, the once-in-a-lifetime rise in what people are willing to pay for equities looks like it has about run its course. A more likely return going forward: 3 to 4 percent after inflation, or about the pace of economic growth.
What to do
Diversify your holdings in two dimensions: space and time. Diversifying across space means owning everything -- U.S. and foreign stocks, bonds, real estate (through REITs) and natural resources.
Diversifying across time means buying steadily regardless of whether the markets bounce up or down. You do that by dollar cost averaging: putting money into your 401(k) regularly or signing up for an automatic investing plan at a mutual fund.
Follow these steps and you won't be overinvested in an asset class that crashes, nor will you ever be putting in all your money at a market top.
Be a cheapskate. If we are headed into a long stretch of blah returns, fees will cut deeper into your profits. Index funds with low expenses have an almost insurmountable long-term advantage over more expensive funds.
Invest more. Sigh. You'll need to put more money into a lackluster market than into a rip-roaring one.
Fear No. 3: The economy collapses
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Worried about the stock market? Start by checking out mutual funds using our Fund Screener.
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