How to Shock-Proof Your Portfolio

Coming up with a plan to reach your financial goals doesn't take a huge amount of work. The challenge comes in how you execute that plan -- and anticipating all the things that will inevitably arise to mess things up.

For example, think about one of the basic tenets of stock market investing: Because the historical long-term average return of stocks is around 10%, you can expect to earn about that much on your own investments. One problem with that expectation is that it's backward-looking -- you may not get 10% returns in the future.

But another concern is more subtle. Regardless of what your average return turns out to be over time, the fact is that during significant parts of that timeframe, the returns you'll earn will be markedly different from that overall average. In other words, while your projections may suggest a nice, smooth line upward for your net worth, reality is likely to be a lot more messy -- and fraught with scary zigzags away from that gently rising trend line.

What volatility does
We financial writers deserve some of the blame here. In an effort to keep investing concepts simple, it's a whole lot easier simply to talk about how a $40,000 investment can turn into over $1.1 million over the course of a 35-year career by referring to a simple average return of 10%.

But that doesn't mean you should expect to have exactly $44,000 after the first year, $48,400 at the end of year 2, and so on. You almost certainly won't.

A tale of two decades
As an example, take a look at how stocks have performed over the past 20 years. If you had tried to plan for a long-range financial goal back in 1989, you might have hoped to have around $67,000 for every $10,000 you invested back then.

As it turns out, a decent number of stocks have had 20-year average returns around 10%. But when you break down those returns, you'll realize just how rough a road you would've taken to get to the finish line:

Source: Yahoo! Finance.

The results make it clear just how uneven your returns can be with individual stocks. In many cases, you more than made it to your overall 20-year goal within the first 10 years -- but if you didn't sell, several of those stocks suffered losses over the next decade.

Obviously, the more you break down a long period into shorter parts, the choppier your returns look. So what's the best way to shock-proof your investment plan, no matter what returns the market throws your way?

Keeping perspective
The best plan is both flexible enough to deal with changing circumstances yet strong enough to withstand challenges. For instance, in the example above, if you were way ahead of your expected track 10 years into your 20-year plan, then a good plan would have reduced your risk exposure to eliminate any chance that you wouldn't reach your goals. If you'd invested in stocks like Citigroup and Schering-Plough, you could have moved all your money to bonds or cash back in 1999 and assured yourself of the money you needed 10 years down the road.

One danger, however, is changing your expectations midway through. That's what many investors did back in 1999 -- rather than locking in their gains, they simply ratcheted up their goals to reflect higher return assumptions. That turned out to be too greedy, and their portfolios got burned by a decade of subpar returns.

Similarly, many people respond to bad markets by getting out of stocks entirely and cutting their future expectations. Yet historically, those who've stayed in the market have recovered much of their losses over time -- and the money they kept putting in when prices were cheap ended up bringing them even better returns.

As lucrative as investing can be, you can't expect the smooth ride that simple projections suggest. As long as you've got shock absorbers for the bumps, however, you'll get to your goals.

For more on succeeding with your investments, read about:

• Stocks that are moving right now.
• Why now's the best opportunity to invest in 35 years.
• Is buy-and-hold investing dead?