Q: I, and my fellow retirees, don't want to hear any more buy-and-hold garbage from advisers. We don't want sermons on 11 percent annual returns in the stock market. We know that when the Nasdaq goes down, 90 percent of mutual funds also go down. Yet we are stuck with mutual funds in our 401(k)'s anyway. We want someone to tell the real story about mutual funds. -- D. H., St. Paul
A: I hear your pain. It sounds like you lost a lot of money when the Nasdaq composite index declined 78 percent after the technology stock bubble burst in 2000, and perhaps you are concerned again because the stock market has been volatile recently.
But I also hear two misconceptions that land a lot of investors in trouble, and cause them to lose money needlessly.
First, when people hear advisers say that stock mutual funds have gained 11 percent a year on average for several years, investors often miss hearing the word "average."
Good times last only so long in the stock market because the stock market runs in cycles--up for a while, down for a while, and then up again.
It is true that if you put $1 into the stock market 80 years ago you would have averaged about 10.4 percent a year, and have close to $2,700 now. But it is critical when you hear numbers like 10 percent or 11 percent that you realize the average is derived from delightful highs and excruciating lows over many years.
You absolutely cannot count on the number in a single year, and no one can tell you with certainty whether you will make or lose money in any particular year--no matter what stock mutual fund you buy. There have been periods like the Great Depression, when the stock market fell 86 percent over a 34-month period, or the early 1970s, when the stock market fell 48 percent over a two-year period.
After that 1973-74 plunge, stocks did not recover for more than seven years.
A loss like that would be devastating for a retiree. So you are wise--as a retiree--to be skeptical of earning 11 percent in a stock mutual fund in any single year. Some years you might earn 20 percent, others you might lose 25 percent. And as a retiree, you probably cannot afford to lose 25 percent of your money in a single year.
When you are younger, and working, the situation is different. You are investing new money, so after declines you partake in the good times with your newly invested money. For example, after the pain of the 1973-74 crash, stocks rose 63 percent over the next two years. As a retiree, however, you would not have had the full benefit of that upturn if you were pulling money out of stock funds during the downturn to pay for living expenses.
Consequently, during retirement you must protect yourself. And you must not fall victim to the second misconception:
When advisers say they emphasize a buy-and-hold strategy, they are not saying to buy and hold any mutual fund.
As you suggest, retirees who put all of their money into a mutual fund that acted like the Nasdaq index in 2000-2002 would have faced a disaster--perhaps a 70 percent loss. Even now, they might still be licking their wounds, or working instead of playing golf. The Nasdaq index remains down 47 percent from its all-time high in 2000.
But not all mutual funds were like the Nasdaq, an index that was destined to crash because it was full of dangerously overpriced technology stocks. The funds that crashed the hardest after 2000 had the word "growth" in their names or descriptions. Other mutual funds were not taking on as many dangerous bets. So while they fell, the plunge was more moderate.
For example, a Standard & Poor's index fund, which buys 500 large stocks, would have lost about 49 percent from its 2000 high through late 2002. It would have averaged a 1.7 percent return since the end of 1999.
That's better than the Nasdaq, but still not a good option alone for a retiree.
Instead, the solution is to invest in stocks and bonds, and not to overdo it in the funds that invest in stocks.
If retirees would have had money in a balanced fund, which invests about 60 percent of a person's savings in stocks and 40 percent in bonds, they would have lost money during the first year of the 2000 downturn, but then recovered. Over the last seven years, they would have averaged a gain of about 8.7 percent a year.
For a retiree, however, even a one- or two-year loss might not have been palatable.
Mutual fund companies have designed certain funds that are geared toward putting people into appropriate mixtures of stocks and bonds based on where they stand before, or during, retirement.
Vanguard, for example, offers the Vanguard Target Date Retirement 2005 fund designed for people who retired in 2005.
A person with money in that fund would have their money divided up half and half in stocks and bonds. The bonds provide protection from downturns, while the stocks help money grow over a 20- or 30-year retirement.
Still, even that mixture might be too unstable for a person further into retirement. Some advisers start retirees with a mixture of 50 percent stock and 50 percent bond funds, but then move slowly out of stocks as the retirement years click by. In their 70s, the mixture can be more like 30 percent stocks and 70 percent bonds.
Gail MarksJarvis is a Your Money columnist and the author of "Saving for Retirement Without Living Like a Pauper or Winning the Lottery." Contact her at email@example.com.