Market risk is just one risk of many
Losing money in the stock market is not the biggest threat to your wallet. People without a large amount of money saved for retirement run the risk of outliving their savings. Those who invest only in very safe investments risk losing purchasing power to inflation.
"Even though investing seems risky, not investing means taking risks, too, when you consider the long-term threat of inflation," says Certified Financial Planner professional Peter Lazaroff, CFA, portfolio manager at Acropolis Asset Management in St. Louis. "If you don't grow your money, you may not be able to afford things in the future. So, you invest to grow wealth and preserve purchasing power."
To mitigate the risk of inflation, investors don't need to swing for the fences, trying to reach for high returns. The historical rate of inflation is around 3 percent. A diversified mix of safe and riskier investments would provide portfolio growth without the danger of it completely cratering in a market downturn.
The stock and bond markets are vast
Stocks and bonds are the meat and potatoes of investing. In general, buying a stock is more risky than buying a bond. Some stocks are less risky than others, though. For instance, you probably won't lose your shirt with an investment in Johnson & Johnson, a large company, versus a wobbly, small company with uncertain earnings potential. Conversely, because a smaller company is more likely to grow a lot versus an established global brand, the potential for a big payoff is greater.
Bonds act in a similar fashion, with very risky companies offering higher returns while very safe borrowers, like the U.S. government, pay very low interest rates.
No matter your situation, there is a mix of investments that will satisfy your goals and risk tolerance -- as long as your goals and ability to withstand risk are realistic and not a fantasy. You can't expect a 100 percent return in three months with no risk.
Planning should reduce risk: Part I
Enter asset allocation. Asset allocation is how you divide your money among various investments. The way you mix investments determines the overall level of risk in the portfolio. With the right mix, you can control portfolio volatility to a certain extent. You also have some control over the level of returns. Higher-risk investments generally offer higher returns; lower risk equals lower returns.
"There are ways to invest so that you are not going to suffer the large loss when we have another 2008 scenario," says Certified Financial Planner professional Matthew Tuttle, CEO of Tuttle Tactical Management in Stamford, Connecticut.
All stocks are not equally risky and all bonds are not equally safe.
Planning should reduce risk: Part II
Buying and selling of investments is inevitable. Whether you regularly rebalance or employ a tactical shift in your asset allocation, having a system in place to tell you when to buy and sell will keep you from panicking and bailing out at the wrong moment.
"Emotions are going to screw you up as a DIY investor, or even a professional. Your emotions are going to mess you up and make you buy and sell at the wrong time," Tuttle says.
A well-planned methodology will take fear and elation out of the equation.
Adopt a placid attitude and an enlightened approach to investing. "This is what I'm going to buy and when. This is what I'm going to sell and when," says Tuttle.
Time in the market, not timing the market
Trying to time the market eventually makes fools of most people, whether on the way into the market or on the way out. No one knows what is going to happen or when.
"Recently we've seen people reluctant to invest in stocks or increase stock allocation because they are concerned that the valuations are too high," says Certified Financial Planner professional Jeffery Nauta, CFA, principal at Henrickson Nauta Wealth Advisors in Belmont, Michigan.
One tool analysts use to gauge the relative value of the stock market is known as the cyclically adjusted price-earnings ratio, or CAPE. It takes the price of the Standard and Poor's composite index and divides it by a 10-year average of earnings, adjusted for inflation.
Through the 20th century, the average was 15.21, according to Robert Shiller, one of the creators of the ratio. Today it's at 26.2.
"That is throwing up yellow flags and may be a reason to take a look at stock allocations," Nauta says.
But that doesn't mean abandoning stocks altogether. "Markets can trade at these higher levels for a number of years and you are missing great returns in the meantime," says Nauta.
Don't wait for the right time. Instead, start dollar-cost averaging into the stock market. That strategy involves investing a percentage of your paycheck into the markets regularly, such as in a workplace retirement savings plan.
The market isn't that rigged
Small investors may have the sense that the deck is stacked against them and they can't win against professional traders with their impossibly fast computers and complex algorithms. And that is largely true. But the good news is that retail investors are such small potatoes that all that stuff doesn't matter.
"High-frequency trading has minimal impact on normal investors. Unless the investor is buying large blocks of securities, it's not eating into their return," Nauta says.
Scandals and scams do erode the public's trust in the stock market, but in the end, not joining in the economic growth leaves regular people behind.
"You can't come up with another way to turn $100,000 into $1 million," says Tuttle, "unless you have a really nice printing press."