What Determines a Stock’s Safety?A stock’s safety is evaluated by fundamental factors such as competition, management, and political change. In other words, the fundamental factors determine the quality of a stock. And quality is obviously important no matter what. This is what investors mean when they say they are invested in “safe stocks”. But the safety of a stock can’t be based on quality alone. There is another big risk factor which is broad stock market risk. This post addresses how safe stocks are for retirement based on broad stock market since fundamental risk can be lowered significantly from diversification. And stock market risk seems to be the least understood and overlooked risk of stock investing, so I want to focus there.
How Important Is Overall Stock Market Risk?Let’s put overall stock market risk in perspective for someone retiring soon. The overall market falls on average about 32% on average in bear markets. This means a bear market declines can be a lot more or a lot less than 32%. Between October 2007 to March 2009, the Dow Jones Industrial Average dropped 54%, for example. On the other hand, during the short and slight bear market in December 2018, the market fell only 20%. (A decline of 20% or more defines a bear market, so it hardly counts as a bear market.) I don’t want to make this seem like a bigger threat to your financial security than it is. And it’s important to realize that a 32% decline may seem like a nonissue given the amount that the stock market usually rises during extended bull markets. For example, the market can rise by 32% in one year alone. And in the 10 years from March 2009, the stock market rose over 300%! But, the two bear markets between 2000 to 2010, however, saw declines of over 54% in at least one of the major stock indexes. These bear markets created overall negative returns as a whole for stock investors in the entirety of the 2000’s decade! Imagine that happening if you retired in 2000. And those big drops in the 2000’s leads me to wonder if future bear stock markets will be worse from the prior average decline of 32%. The averages don’t look so bad, but a 54% decline in your stock portfolio is really bad when you don’t have decades to recover. These facts compel me to write this post for stock investors wondering if stocks are safe for retirement.
Are Funds Safer than Stocks?Many investors today are invested in funds of some type, such as index funds, ETFs (Exchange Traded Funds), or mutual funds instead of individual stocks. And many investors are still invested in individual stocks. Many high net worth investors, for example, have private wealth managers invest in individual stocks for them instead of funds. While funds provide instant diversification making them a little safer than individual stocks, both funds and individual stocks are subject to the risk issues outlined below.
The Overall Stock Market Affects Stock RiskInvesting in stocks is about investing in the stock market as a whole since almost all stocks move up or down relative to the overall stock market. In other words, almost all stocks go up during rising (bull) stock markets and almost all stocks decline during falling (bear) markets. For example, my article entitled Stocks That Went Up in 2008 outlines the few stocks that did move counter to the market (up) in 2008. It was hard for me to find enough stocks for that post, and some of those stocks declined during the bear market as a whole. Often, investors (or their financial advisors) buy stocks that go up during a strong rising (bull) market. They feel brilliant for either choosing the stock or hiring the financial advisor but it was the market as a whole that should get credit for that gain, not stock (or fund) picking prowess. (I’ve been there and done that.) While a stock’s fundamentals (earnings, competition, management, etc.) are extremely important in evaluating an investment, the stock will almost certainly move with the overall market trend up or down even when the fundamentals are outstanding. This means that the term “safe stocks” must be defined by long term overall market trends as well as company fundamentals.
Stock Purchase Price Affects RiskThe amount you pay for any asset defines whether you will have a gain or loss from the sale of that asset. This means that the purchase prices affects how safe a stock is. And the purchase price of a stock is a factor of the overall stock market trend. Here is an example: If you bought a stock in 2009 at $20 and the value is now $ 120, a decline of 34% won’t create a loss if you sell the stock. On the other hand, if you bought a stock in 2019 at $120 and it falls 34%, you’ll have a loss if you need to sell the stock. This math is obvious but here is the important thing to notice: In 2009, the stock market as a whole was very cheap because the 2007 – 2009 bear market ended in March of 2009. “Very cheap” means stock market “valuations” were low. This means the purchase price for almost all stocks were low. In the second scenario above, in 2019, the stock market was expensive, meaning the market had high valuations. As you can see, investing in stocks is like shopping for anything else. You actually get to choose if you want to buy assets that are expensive or cheap relative to “normal (average) pricing”, it just feels like you don’t. Many investors don’t realize this important fact since there is a lot of promotion to invest in stocks no matter what the valuations are. This leads investors to feel unnecessarily pressured to invest in stocks, often at inopportune times.
A Stock’s Safety Is Ever ChangingA stock defined as “safe” 10 years ago may not be safe today based on valuation alone. For example, most quality stocks were very safe from a valuation perspective in early 2009 near the end, and after, the bear market. But from a valuation perspective, that same stock may not be safe from a valuation perspective 10 years later as you head into retirement. (Remember, valuations are largely affected by the broad stock market.) The good news is that valuations can be measured with the Price-Earnings ratio. The price-earnings ratio shows how much an investor has to pay for a company’s earnings. While the PE ratio can be misleading at times, it is still considered a very reliable and basic way to know how much you are paying for the earnings of a company before buying a stock. As a very general rule, lower PE ratios are associated with safer stocks. (It’s important to note that the quality of a stock based on fundamentals is also important because bad fundamentals also cause low PE ratios.)
Timing Is EverythingUnless you are very wealthy already, retirement is not the time to plan on long term appreciation from stock ownership. The exception to this is if stocks are bought at low valuations since quality stocks return to normal (average) valuations thereby building wealth as they do. Stocks move back toward the mean pricing, which is an average. But they swing both under and over the mean when creating that average creating opportunities for stock investors paying attention to long term stock market trends. This means that how safe stocks are for retirement is a factor of the valuation which they were bought. You can read more about this in my article How to Know If Stocks Will Go Up and How to Increase Wealth before Retirement.
Define How Much Risk from Stocks You WantIt’s easy to feel like a victim to the stock market. At any given time, however, you can choose how much stock market risk you want to take. There are many ways to lower stock market risk as the markets rise. One easy way is to use stop loss orders, which can be then entered to keep your stocks at, or at least near the risk level you choose. While you can get “whipped around” due to markets rising right back up after your sales get executed, times of increased volatility are usually worth the extra risk management. If you work with a financial advisor, you have probably defined your chosen stock risk level with her. You can simply ask her to implement strategies to stay within those chosen risk levels. If you buy your own stocks or funds, you can enter stop losses in your brokerage account if you decide this is best for you. You can read more about this in my articles: how a stock market crash will affect you, ways to reduce risk while building wealth, and what percentage of cash should be in your portfolio.
You Don’t Have a Loss If You Don’t SellCommon theory around long term buy and hold investing (regardless of stock market valuations) emphasize that you don’t have a loss if you don’t sell stocks at a loss. The plan is to ride out bear stock markets. This can work well for those with decades before retirement but not so well for those about to retire or retirees. Even if you don’t incur a (realized) loss from the sale of stocks, you have a painful net worth decline which affects your overall wealth plan.
Dividend Stocks Are SaferFortunately, during bear stock markets, most higher quality stocks that pay dividends tend to fall less than the overall stock market. For example, quality dividend stocks may fall 35% during a bear market with an overall decline of 50%. Since many retirees are invested in dividend stocks for income, this makes them safer in retirement especially since the needed income continues even during bear markets. Read my post entitled Is Dividend Investing Worth It? and When to Switch from Growth to Income for more on this.
Beta Measures How Safe a Stock IsYou may feel like you have no way to know if stocks are safe based on the likelihood of a bear market. But you can easily see how safe a stock or stock fund is from a broad stock market perspective with a measure called Beta. Think of it like this. The overall market drops on average about 32% during a bear market. The Beta measures how much a stock or a stock funds drop in relation to the overall market. If a stock (or fund) has a Beta under 1.00, for example, it tends to drop less than the overall market. An example would be a stock with a Beta of .92. If a stock drops more than 1.00, it tends to drop more than the overall market. An example would be a volatile fund with a Beta of 1.50. Of course, this works both ways. Stocks also rise in relation to the overall market based on the Beta. Logically, then, it makes sense to invest in higher Beta growth type stocks in the early phases of a growing economy and lower Beta stocks near a slowing economy. Remember, stock market cycles are usually tied to the economic cycle in a very logical way. And the Beta is based on logic and math. Logic and math are my favorite investing tools. You can see how using the Beta can help you affect how safe stock investments are for retirement. The Beta is a free tool that is easily available if you invest yourself. Here is one of many sites that publish the Beta of a stock. Notice that Beta is based on historical data. If you work with a financial advisor, you have hopefully had a good conversation with him about using Beta as a risk management tool and how it applies to your investments.
Summary: Are Stocks Safe for Retirement?As you can see, whether stocks are safe for retirement depends on many factors. There is rarely a one size fits all explanation here at Retire Certain. This is because you have to understand the basics of investing as well as define your own personal wealth plan. Once you have done this, you’ll know if stocks are safe based on the risk that you choose to take at any given time before or after retirement.
The information on this website is for education only and is not to be construed as personal financial advice.