Rethinking the risk of stocks

(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.

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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).

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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.