While it may sound goofy, those of us still contributing to our retirement plans should pray for periodic stock market crashes. This thought is an appropriate follow-up to last week's column citing one analyst's work that suggests the possible existence today of a stock market bubble.
What's so great about a crash under any circumstances? Well, it's an opportunity for inbound contributions to achieve very high rates of return -- which increases the average rate of return for our entire account. For example, a few hundred dollars contributed as recently as March 2009 has more than doubled in just 4 1/2 years. Assuming that those particular contributions were invested in, say, a total stock market index fund, the annual rate of return over the past 4 1/2 years would have been more than 16 percent. And this doesn't count the added 2 percent or so of reinvested dividends.
A younger person, having just contributed every pay period into stock market mutual funds for the past 10 years, should have earned an average return of about 12 to 14 percent per year. By comparison, someone who hit a jackpot 10 years ago and invested a one-shot lump sum amount in the same funds would have earned about 8 percent per year.
The difference comes from the downdraft and opportunity caused by the crash. Warren Buffett recognizes this when he says, "people buy socks when they're on sale, but they need to learn to buy stocks when THEY are cheap." The dramatic difference in rates of return says a lot about the value of continuing to invest while the market is plunging.
Having made this point, it stands to reason that a seasoned retirement account within 10 years or so of having to fund a retirement lifestyle may not be an ideal candidate for capitalizing on a major crash. It's just too close to the end point for most people to endure psychologically, so there are some alternatives that may make sense.
First, there is old money and new money in a typical retirement plan. Old money is the total current account balance. New money is the expected flow of future contributions. Retirement plans like 401(k)s allow a distinction between how the existing account balance will be invested versus the investment mix for new money. Consider investing the new money aggressively to capture the higher returns in the example cited above while, at the same time, investing in the existing account balance more conservatively.
How conservatively? Well, the sweet spot is to have about one-third in bonds for maximum protection at the least cost of giving up what would have been future gains. Also, to the extent that stocks have to be in every portfolio well into retirement, the most conservative are those of large companies that pay dividends. So, investing in a combination of bond funds and funds investing in dividend-paying stocks makes sense for this old money.
The new future money can be invested aggressively. An investor can fool around with these dollars. The more aggressive the better. New money will be a relatively small percentage of the total amount of the nest egg. However, a high average annual return fueled by a crash and a snapback could move the needle positively for the entire account.