Source: Gold Footpath by George Hodan.
Whenever the stock market gets turbulent, those in or near retirement get nervous. They spend decades saving up their retirement nest eggs, which are often meager. It might take no more than a single market crash to wipe out a lifetime of work. And even though the market managed to turn the tide of pessimism once again in late September and October, retirement investors can't afford to count on the bull market lasting forever -- because it won't -- and sooner or later, the market will experience another crash on the order of what investors suffered in 2008 and the early 2000s before that.
But just because down markets are inevitable doesn't mean that you shouldn't invest in stocks. In fact, if you have the right investment strategy, a market crash can become a once-in-a-lifetime opportunity. What's essential, though, is making sure that you don't get overextended beyond your true risk tolerance and end up making mistakes that will crush your retirement dreams for good.
Warren Buffett. Source: The Motley Fool.
The biggest mistake retirement investors make
Billionaire investor Warren Buffett has famously urged investors to be greedy when others are fearful and fearful when others are greedy. Buffett's insight shows just how important investor sentiment is to what happens in the overall stock market, and the herd mentality clearly exists in both bull market surges and bear market crashes. Getting too wedded to popular opinion can be hazardous to your investment returns, especially in choppy markets.
Yet the biggest mistake that retirement investors make is being too confident in their ability to buck the popular perception when markets crash and to withstand the urge to join the crowd by selling out. It's all well and good to say that if the market plunges, you'll be the last one to panic and the first to buy all the great stock prospects you have on your wish list. But when the reality of a market crash sets in, it can be next to impossible to resist the temptation to sell and cut your losses.
As an example, consider the financial crisis of 2008. In the future, most investors who didn't experience the market meltdown firsthand will think those who witnessed it are grossly exaggerating when they say that the global financial system was on the brink of collapse. Decisions to sell at ridiculously low prices will look completely irrational in hindsight, especially given the speed at which the market recovered. After all, within just a few short years, the Dow Jones Industrials (^DJI -0.11%) and other stock market benchmarks were back at all-time highs, and earnings among most industry groups had fully recovered from their crisis-era pullbacks.
Source: Flickr user o5com.
Experience, though, tells a much different story. When you're actually going through a long period of uncertainty, it's easy, at first, to withstand pressure to sell. But as negative news items build up and point to ever more disastrous possibilities, that selling pressure grows, even as your paper losses mount and eat into your net worth. At some point, many people find that their resistance breaks -- and they choose what often turns out to be the worst possible time to sell.
Millions of Americans saw that exact scenario play out in 2008 and 2009. When they sold out, they accepted big losses -- and then never regained the confidence to take advantage of the market rebound that followed. Many will never have a chance to get back to the levels of wealth they enjoyed before the financial crisis because of that one simple mistake.
Avoid the crush of the next crash
The key to surviving a market crash is having exactly the amount of stock market exposure that you'd feel comfortable holding while you ride out a long downturn in the market. You want to put yourself in a position where it's easy to ignore what's happening with stocks, allowing you to have the longer-term perspective that removes emotion from the investing process and lets you stay rational and take advantage of bargain opportunities as they arise.
Source: Flickr user Jim Linwood.
Interestingly, now is just about the perfect time to make adjustments to your portfolio to get your risk levels back in sync with your risk tolerance. After their September and early-October slide, stocks quickly rebounded, giving investors a chance to sell and raise almost as much cash from their trades as they would have gotten if they'd sold before the correction. By having that cash on hand, you won't earn as much in profits if the market keeps rising from here -- but you'll be in a better position to avoid losses in the next crash and make strategic purchases when the opportunity comes along.
If you want your assets to grow over time, you have to accept some risk. But in order to prevent the next market crash from crushing your retirement prospects, it's crucial to tailor your risk to your investing demeanor so you can stay the course no matter what happens.
