Investing in riskier assets: Bonds
Individual investors are not hiding their money in holes in the backyard. Instead of going to stocks, many investors have piled into bonds and bond funds over the past three years.
According to the Investment Company Institute, the trade association for the mutual fund industry, in February of this year, stock mutual funds posted outflows of $1.19 billion.
Conversely, bond funds had inflows of $34.13 billion for that month. That has largely been a trend since the financial crisis began in October 2008, with stock funds experiencing outflows 66 percent of the time, and bond funds getting inflows 81 percent of the time.
The perception is that bonds are always safer than stocks. But the risks in bonds are higher than people believe, says Larkin. People with a very low tolerance for risk may be surprised to learn that the value of bonds will go down when interest rates go up -- this is particularly the case with long-term bonds.
For bondholders who will own individual bonds until maturity, that's not necessarily an issue. But bond fund investors will see the value of their investment fall, which may be precisely the outcome they were trying to avoid.
"If the Fed does have to act, that's going to really impact the bond market in a negative way," Larkin says.
Individuals may not be aware that the bond market will reflect the Fed move before it happens, which makes timing an escape tricky.
"The market always reacts in anticipation of the change, never when it happens. It's always way beforehand. When it comes to raising interest rates, about three-quarters of the change happens before they even start to make the change," says Larkin.
Investments are pieces of a whole
Investors can lose sight of the forest for the trees when it comes to their investment portfolios. Avoiding major asset classes can increase risk rather than reduce it.
Rather than making reactive investment decisions based on external events, "take a holistic approach to the management of your portfolio. You should have an asset-allocation model division between bonds and stock generally, but also different kinds of bonds and different kinds of equity positions," says Robert Fragasso, CFP, chairman and CEO of Fragasso Advisors in Pittsburgh.
The way you divide your investing dollars should reflect your goals, time frame, risk tolerance and as retirement nears, your income needs.
Investors with a very long time to invest will likely see the best results from investing in the stock market. That's especially true for young people, with a time horizon of several decades. Unfortunately, young people are only marginally more inclined than older generations to invest in stocks. Just 23 percent of 18- to 29-year-olds answer affirmatively to investing in stocks compared to 18 percent of respondents between the ages of 50 and 64, according to Bankrate's survey.
Over a long period of time, the returns on the stock market have historically averaged between 8 percent and 10 percent. There's no guarantee of that continuing, but experts predict it probably will.
"This time is not different," Fragasso says.
"That's why people are sitting on the sidelines three years after they should have invested and missed a hundred and what -- twenty percent recovery?" (The recovery was actually about 110 percent as of early April from the stock market's 2009 low.)
Stocks likely the least scary part of the system
While stock market volatility is scary, at least it's a known risk.
When it comes down to it, the deck is stacked against individual investors in many significant ways. Many of the most dangerous parts of the financial industry are hidden from view. For instance, the financial crisis revealed the scope of under-regulated derivatives markets. Financial innovations designed to make a few people a lot of money ended up costing everyone tremendously.
Staying out of the stock market does not preclude investment losses nor does it guarantee financial well-being.
Investing in the stock market can be uncertain, but sitting on the sidelines can also be costly. While there are ways to mitigate the risks of the stock market -- by diversifying among different asset classes and buying low-cost index funds, for instance -- the only way to lessen the opportunity cost of staying out of the market is to save more money.
As with everything in life, meeting long-term financial goals requires taking calculated risks.