The Dow is down to its lowest levels in four years. The tech-heavy Nasdaq has hit 5-year lows. Business scandals make headlines across the country, and families tighten their belts in the face of declining stock portfolios. Given all this, is it time to pack it in, give up on the market and park your retirement money under a mattress? Hardly.
Despite all the bad economic news lately, the stock market is still the best place for retirement savings – as long as the investing is done properly. There are two basic rules to remember for retirement investing: Diversify and think long term. Yet people saving for retirement often violate both rules.
Last year, thousands of Enron employees lost much of their retirement savings when the company stock price fell dramatically. But Enron's case is not unique. A recent study by the nonpartisan Congressional Research Service found that company stock accounts for 38 percent of the assets in the average employee defined-contribution retirement plan.
As Enron demonstrates, investing much of your retirement eggs in the same basket is risky, even if the basket is a large corporation and/or the company you work for. Investors can loose their shirt if the stock they have concentrated in performs poorly.
In addition, many people don't think long-term when investing for retirement. Clearly, the market is down now. It goes up and down all the time, and that can be downright scary for inexperienced investors. Despite all the ups and downs from day to day and even year to year, the market always trends upwards over time.
If you are investing for retirement, you will be investing for 35 to 40 years. Over any 35-year period in the last 128 years – a time frame that includes the Great Depression, two World Wars and several recessions – the market has returned an average annual rate of return of 6.4 percent. The lowest-earning period, which ended in 1921, yielded an average real rate of return of 2.7 percent.
That means long-term investors do fine, even if there are down years while they hold their accounts – as long as they choose a balanced, diversified portfolio and maintain the balance from year to year.
Think that is hard to do? Try what personal finance columnist Scott Burns calls the "Couch Potato Portfolio." A would-be investor with no prior knowledge or expertise can build a secure retirement portfolio by purchasing index funds that reflect the performance of the market as a whole. For example, the Couch Potato can invest in a 50/50 mixture of the Vanguard Total Stock Market index fund and the Vanguard Total Bond Market Index Fund (or any of their competitors).
How has the Couch Potato portfolio compared with other investments over time? Last year, the Couch Potato portfolio lost only 1.8 percent, compared to the 11.32 percent loss suffered by the average domestic equity fund. In fact, over the last 3, 5, 10 and 15 years, the Couch Potato portfolio outperformed the average balanced fund and the average domestic equity fund. And remember, by following the stock market as a whole, the Couch Potato investor will make out fine over the 35 to 40 year life of his investment, even if there are down years.
That's why plans to allow younger workers to invest a portion of their Social Security payroll taxes in personal retirement accounts make sense. For younger workers, investing wisely in the stock market will lead to a more secure retirement than Social Security can provide.
Remember that Social Security is unsustainable in its current form. When the Baby Boomers start retiring within the next decade, the amount the rest of us pay in taxes won't be enough to pay for all the benefits we've promised. Between then and 2075, when today's newborns will have retired, Social Security's debts will total more than $25 trillion. Already, Social Security provides a meager 2 percent return or less on taxes contributed. If we have to raise taxes or cut benefits to close this gap, the return will become negative.
Younger workers should be able to put some money aside in an individual account, invest it wisely over their working life and reap the rewards of years and years of compound interest. By harnessing the long-term growth potential of the stock market, we can pre-fund the benefits of tomorrow's retirees and avert a financial disaster down the road.