When the markets were flying high, everyone bought stocks. But now that the bear market has taken hold, people are fleeing in droves -- and long-term stock investors will benefit going forward.
For over a year, you've watched your portfolio lose value month after month. Even the most patient investors have started to get restless about their investments and whether they're doing the right thing with their money.
Yet in just a short time, the falling stock market has accomplished something that will potentially boost your returns for years to come. By reasserting the risk portion of the risk-reward trade-off that stocks offer, the downturn has given steadfast investors the chance to earn greater returns down the road than they got when nearly everyone had money in the stock market.
The paradox of risk
In this month's brand-new issue of Rule Your Retirement, Fool retirement expert Robert Brokamp goes into depth about risk and what it means for stock investors. In a conversation with guest commentator and financial author Larry Swedroe, Robert explores what I call the paradox of risk in stocks.
From an investor's perspective, you'd obviously prefer to have all the benefits of higher returns from stocks without any of the downside. That's why the period from 2003 to early 2007 was great -- you enjoyed healthy double-digit returns without suffering any big, lasting declines. All you had to do was invest and wait, and you saw your investments steadily rise in value.
But when other investors see people earning big returns without any apparent risk, they pile in. After all, if stocks really aren't risky, why settle for rock-bottom yields on bonds and bank CDs when you can grow your money much more quickly in the stock market? The resulting extra demand for stocks pushes prices up and reduces the potential for future returns -- because no matter how many buyers there are for a stock, the underlying company can only generate a finite amount of current and future profits.
Responding to the crash
In contrast, when the markets drop dramatically, all those fair-weather investors suddenly realize that stocks weren't the fail-safe opportunity they had hoped for. They're the ones who sell in a panic at market lows, retreating to low-interest bonds and cash investments until they get suckered back into the stock market after the next rally.
But all those sellers do a big favor for disciplined long-term investors. By knocking down prices of shares, they make investing cheap for those with the courage and determination to follow their overall investing strategy even during bear markets. And by scaring off casual traders, they leave more room for true investors to capitalize on great opportunities.
Demanding more for your money
You can see one example of this phenomenon in the earnings yields that investors demand from companies. During the bull market, earnings yields got ridiculously low -- in part because of lofty growth projections, but also due to the high demand for stocks.
Yet if you look at the same companies now, you'll see that their earnings yields have gone up dramatically -- more than you'd expect, even in an economy where future growth seems likely to fall. Take a look at some examples:
|
Stock |
Earnings Yield in March 2007 |
Current Earnings Yield |
|---|---|---|
|
NYSE Euronext |
1.46% |
13.04% |
|
Big Lots |
3.22% |
13.79% |
|
eBay |
2.38% |
10.27% |
|
Monster Worldwide |
2.47% |
11.1% |
|
Marvel Entertainment |
2.43% |
8.3% |
|
Coach |
3.04% |
14.6% |
|
Viacom |
5.33% |
16% |
Source: Capital IQ, a division of Standard and Poor's. Current yield as of Feb. 5.
Investors who've come to realize that they can't count on high growth during a recession are now demanding much more proof of actual earnings from companies. With earnings yields at much higher levels than they were two years ago, shareholders can expect to see much greater returns on their investment over the long haul -- especially once the current recession ends and profits begin to grow again.
You're still here
Of course, if you've stuck with your long-term strategy and held stocks through the downturn, you've already paid a high price on your current holdings to get to the point where stocks look incredibly attractive again. But remember: Your retirement relies just as much on the money you'll invest in the months and years to come as it does on what you've already saved. Over the long run, if the panic keeps weak investors away, you'll end up the winner.
If you want to read more of Robert Brokamp's conversation with Larry Swedroe, it's easy: Just join us at Rule Your Retirement. It's a subscription service, but you can get a sneak peek absolutely free just by clicking here.
For more on making the most of retirement, read about:
- How you can save your retirement.
- Why risky stocks need to be part of your portfolio.
- Why you need to prepare now to avoid a gruesome retirement.
