It's a proven fact that people hate losing money. In fact, according to researchers Daniel Kahneman and Amos Tversky, it physically pains us.
With that as background, it's easy to understand why so many people who are planning for retirement have made protecting their principal paramount. And they're likely succeeding. After all, it's easy to protect your principal as along as you invest in nearly risk-free investments such as CDs, Treasuries, and high-grade bonds.
But such protection comes with a cost. And that cost -- to put it frankly -- is crappy returns.
Who needs returns?
One of the worst aspects of the market decline from 2000 to 2003 was that it seriously rattled investor confidence. And while the lesson that the market is no get-rich-quick scheme is a valuable one, there is no substitute for stocks when it comes to supercharging your retirement savings.
Consider, for example, the scenario for a future retiree who refused to be rattled by the market decline. In 1997, this investor started investing $4,000 per year in Vanguard 500 (FUND:VFINX), a low-cost index fund that tracks the S&P 500. Our investor therefore has a position in a basket of large caps that currently includes Hewlett-Packard (NYSE:HPQ), PepsiCo (NYSE:PEP), and Wachovia (NYSE:WB).
While there would have been declines of 9%, 12%, and 22% in 2000, 2001, and 2002, our future retiree would now have more than $62,000 in savings as a result of just $44,000 in principal investment.
Contrast that situation with someone who got spooked by the market's drop and decided to move all savings and future contributions to Vanguard Total Bond Market (VBMFX) in 2002. That investor has achieved less volatility by investing in the Treasuries, mortgage-backed securities, and the bonds of large companies such as Aetna (NYSE:AET) and AIG (NYSE:AIG), but currently has just $46,000 in savings.
In other words, stocks and the ability to stick with stocks made nearly $20,000 worth of difference over just 10 years.
Scary statistics ahead
Maybe $20,000 in 10 years doesn't seem like a lot of money. But given that this isn't a shiny, happy time for future retirees, the sum matters. According to a recent Fidelity Research Institute survey, Americans are on track to replace just 58% of their current income. Just 58%! So if money is tight now, it's only going to get worse.
And that's a reality that today's retirees are already facing. That same Fidelity survey revealed that financial strain is the No. 1 reason why current retirees have found retirement less enjoyable than expected.
The stocks you need
So, while the first step to a secure retirement is fully funding your retirement accounts, the second and no less important step is to make sure that your accounts are invested intelligently. To that end, let me recommend that you allocate at least a portion of your account to Vanguard Small Cap Value (VISVX).
This low-cost index fund was recently highlighted as one of the best funds investors can own in our Motley Fool Rule Your Retirement planning service, and the segment of the market it tracks, which includes Lubrizol and Shaw Group (NYSE:SGR), is historically the best-performing segment of the market overall.
If you'd like to learn more ways to defend your wealth, perfect your retirement portfolio, and achieve the good life, consider joining Rule Your Retirement. The service can help you figure out ways to save more, earn more, and minimize the taxes you pay to our good government. And if you're looking for a quick, eight-step crash course, the service has that too. Even better, you can take a look at all of its resources free for the month. Click here for more information.
This article was first published on May 24, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. The Fool's disclosure policy loathes cruddy returns.
