Should You Be In the Stock Market?

Photo by: mvhargan

I often hear people tell me that they’ve stopped contributing to their retirement account because they don’t think the stock market is going to go up.  It seems many of these people assume that a retirement account and the stock market are one and the same.  Most plans have many options, and nearly 64% have actively managed bond funds as an alternative.1

The fact that many people don’t even know what their options are in their retirement accounts suggests to me that they probably shouldn’t have been in the stock market in the first place.  Many people were initially sold on stock market-based retirement account options by claims that the stock market returned 8%, or 11%, or whatever their advisor was telling them. They put their finances on autopilot and never looked back.  At least they never looked back until 2008.

The Risk Premium

The philosophical rationale for why stocks should outperform “safe” investments, like government treasuries, is something called the risk premium.  In theory, if equities did not outperform safe investments, then rational actors would cease to buy the equities. The prices would decrease to a level where there would be an adequate risk premium.

This theory was put to the test during the recent financial crisis when, at the nadir of stock prices, there essentially was no risk premium for the previous thirty years.2  Since then, stocks have rebounded a good deal and the risk premium has returned. However, it points out an important fact: the risk premium is only likely in the long term and is not guaranteed.

Risk Tolerance

Because of the wild variability of the risk premium, the value proposition of equities decreases as you get closer to an expected retirement date.  Once you have a near-term window for beginning withdrawals, the amount of time your returns have to “average out” decreases, and your exposure increases.  As you get closer and closer to retirement, equities should become a smaller and smaller portion of your portfolio.

The Macroeconomic Picture

The final, and most important, question is:  Do you still believe in the American Economy in the long term?

Ultimately there are many other fish in the sea and there’s no reason you have to be invested in American stocks, or even in stocks at all.  In an era of declining stock prices, being flat is better than losing less than others.  The macroeconomic picture can be conflicting and confusing right now, so it can be hard to decide; but there are plenty of things to fear.  If you haven’t measured your thoughts on these subjects or discussed them with your advisors, the sooner the better.

You should never approach the stock market as your only investment option.  Think about your position in life and whether your goals are the same as when you started your investment plan.  Automatic investing in the stock market has been a solid choice for many years now, but before you commit any more money to the plan, clarify in your mind why you’re doing so.

1. PSCA.org – 51st Annual Survey of Profit Sharing and 401(k) Plans [↩]
2. Bloomberg.com – Bonds Beat Stocks in ‘Earth-Shattering’ Reversal: Chart of Day [↩]

One Response to “Should You Be In the Stock Market?”

1. BMB says:

   August 18, 2009 at 7:47 am

   So true. I know of many older folks, friends and relatives included, that lost large portions of their retirement in this latest market decline. One of the things we’ve wondered is why — at the age these people are at — they aren’t placing more emphasis on capital preservation rather than putting their assets at risk in stocks.