It's natural to be worried about stock market crashes. After all, with a portfolio worth $300,000 and a 20% market drop, you could lose a whopping $60,000 in short order. That shouldn't be a major worry for most of us, though -- our portfolios may face bigger risks.
For starters, many investors have not sufficiently diversified their portfolio. If, for example, your portfolio holds three stocks in roughly equal proportions, you've got about 33% of its value in each of them. If one implodes, it will make a big dent in your nest egg. This situation can get worse if one of the stocks grows much more briskly than the others -- as it can grow to be worth 40% or 50% of your portfolio. That's too many eggs in too few baskets.
Holding many dozens of stocks can be overkill, though, as you won't be able to keep up with them all, most of them won't be your best ideas, and each one will likely have little effect on the overall portfolio value, even if it surges. You might aim to hold between 10 and 20 stocks, as long as you'll be able to keep up with them all. If not, consider a broad-market index fund or two, that needs little oversight.
Another way many folks are under-diversified is if much of their retirement money is invested in their employer's stock. In that situation, you're relying on your employer not only for your current livelihood but also your future. That's a lot riding on a single company, even if you know it well.
Another major risk many investors face is not saving enough for retirement. If you don't take the time to determine how big a nest egg you need, you will just be saving random sums and hoping for the best.
One way to get a ballpark figure is to estimate how much annual income you'll need in retirement and subtract from it what you expect to get from pensions, 401(k) and IRA withdrawals, Social Security, and so on. (The average Social Security retirement benefit was recently $1,338 per month, or about $16,000 per year.) What's left is what you'll need to fund on your own. If your income gap is, say, $20,000 per year, to get a rough idea of how big a nest egg you'll need, assume 4% withdrawals. That means the $20,000 will be 4% of your portfolio value. Multiple it by 25 (because 100 divided by 4% is 25) and you'll get an initial portfolio value of $500,000.
Most of us should sock away money for retirement rather aggressively, at least while we're young and our money has many years to grow. As we get older, if we have sizable assets we might let up -- or keep being aggressive in order to be on the safe side or retire early.
Many investors under-research. That's what's going on if you read an article that makes a few good points about a company's advantages and then you buy stock in the company, without any or much further research. Remember that there's a pro and con case to make about just about any company. Don't neglect to consider the risks any company is facing. Look for red flags such as shrinking profit margins, large and growing debt burdens, growing competition, and so on.
If that sounds like too much trouble, consider just sticking with an inexpensive, broad-market index fund, such as the SPDR S&P 500 ETF (NYSEMKT:SPY), Vanguard Total Stock Market ETF (NYSEMKT:VTI), or Vanguard Total World Stock ETF (NYSEMKT:VT). Respectively, they distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market.
Being overly emotional
Be sure to keep your emotions in check when investing, too -- otherwise you may panic and bail out of great stocks just because there's a temporary market downturn or you may load up on overvalued stocks because others are piling in and you don't want to be left out of possible profits. Greed and fear drive too many investment decisions, often with poor results.
When you should worry about a stock market crash
The risks above are well worth thinking about, and most of us needn't spend much time worrying about market crashes. But some of us should give them some thought. If you have any money you expect to need within the next five or so years (even 10, to be more conservative), you're putting it at risk in the stock market, because the market will swoon every now and then. Short-term money should be in less volatile places, such as CDs, savings accounts (ideally when interest rates are higher), and so on.
Remember that even though it can freak you out to see the market dip or crash and your portfolio suddenly be worth considerably less, you haven't actually realized a loss yet. That only happens if you sell. If you can hang on -- and perhaps even buy more while prices are low, you can come out fine once the market recovers.
It's good to worry a little about your investments and to keep an eye on them -- but be sure you're worrying about the right things. And with many worries, such as under-diversifying, under-researching, under-saving, and being emotional, you can address and remove them.
Selena Maranjian has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.