Looking at a chart of inflation-adjusted monthly stock market returns from 1886 to now, it's apparent that stocks fall into bear markets — a drop of 20% — from time to time.
The chart I'm looking at was stitched together by Paul Kaplan, director of research with Morningstar Canada. One lesson he draws from the data is that after every bear market over the past 150 years the stock market eventually recovered and went on to new heights. The patient investor has been rewarded, at least so far.
The second lesson is market crashes significantly differ. "Not all crashes are alike in their severity and duration, and naming the market's peak or bottom is difficult," he writes. "Therefore, the best bet is to prepare now for the next crash by owning a well-diversified portfolio that fits one's time horizon and risk tolerance."
Kaplan is spot on. Owning a well-diversified portfolio is a savvy risk management strategy, especially for those saving for retirement. Diversification doesn't only protect from downside risks, either.
"I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place," said Peter Bernstein, an economist and philosopher of risk, in an interview years ago with Wall Street Journal columnist Jason Zweig.
Investment risk is only one kind of risk. Dealing with other kinds of risks can call for a different approach, such eliminating the risk. For example, risk for many people nearing retirement is that things won't work out as planned.
"For you, risk is not being able to fund that standard of living in retirement," writes Bob French, director of investment analysis for Retirement Researcher. "Anything that makes reaching or maintaining that more likely reduces your risk, and anything that makes this less likely increases your risk. Everything else is details."
My own sense is that three household risks stand out with retirement planning. They're carrying too much debt; not finding a job that brings in additional income; and the home becomes an albatross later in life.
You may face one of these risks, some mix of them, or different risks altogether.
But the combination of a well-diversified portfolio coupled with eliminating or greatly reducing the risk that poses the greatest threat to your household's future standard of living is a strategy for dealing with all economic and market seasons in retirement.
Farrell is economics contributor to the Star Tribune, Minnesota Public Radio and American Public Media's "Marketplace."
