Investing in stocks is like driving a car on a crowded road.
OK, investing in stocks is not like driving a car on a crowded road, but bear with me.
When you learn to drive, one of the most important skills is judging speed. You can learn some tips in driver education, but the real learning occurs over time as you build experience driving in different conditions.
You learn that some conditions are more risky than others - bad weather, heavy traffic and so on. Your best bet is to slow down, unfortunately not all drivers learn this lesson and suffer the consequences.
If you are honest with yourself, you know that your vision and reflexes diminish with age and a slower speed is appropriate. Sadly, too many young people believe they will live forever and the rules (and common sense) don't apply to them resulting in tragedy.
However, when in comes to investing in stocks, young people can actually afford to "step harder" on the accelerator (make risky buys that may payoff big, but have a high chance of failure).
Even if the worse happens, young investors still have decades to recover. Unfortunately, the same can't be said for older investors. Just like the driving example, older investors need to back off the accelerator, just as they would when pulling up to a stop sign.
In this case, an accident (big market reversal) can cause damage that the older investor may not have time to recover from. If you are going to be in an accident, it is better to be going slower, not faster.
For investors in the stock market, this means following an important rule that governs the balance of risk and reward.
Investing in stocks has always been about balancing risk and reward.
Since each investor has a different tolerance for risk, there are few rules that generally apply across all investors.
There is one rule that I would strongly encourage you to pay attention to.
Don't put money into the stock market (or leave it there) if you will need the cash within five years. Consider five years the stop sign your are pulling up to and slow down.
Does this mean cashing out of the stock market when you hit 60 and plan to retire at 65 (who can afford that these days)?
Not exactly. What it does mean is that you should be looking for an opportunity to extract cash from your stock holdings long before you need the cash.
You might argue that pulling out early means you may miss an opportunity for additional profits.
That is correct. If you are not invested in the stock market, you will not profit from a bull run.
However, time is working against you as well as for you.
If you are nearing retirement and counting on cash from your investments, your risk tolerance should be much lower than when you were 35.
Here's why. When you are near retirement, you cannot afford a catastrophic loss.
In calendar year 2008, the Dow lost more than 5,500 points between its high and low for the year.
Approximately 42 percent of its value evaporated.
Could you stand such a loss at retirement?
The argument that this was a "once in a lifetime" event is bogus. The same thing happened in the bear market of 2001-02.
Huge percentage losses destroyed portfolios. Younger investors recovered, but it took most of a decade to do so.
The lesson: If you are nearing retirement (or any other financial goal), don't risk a large exposure to the risks of a huge downturn.
It has happened before and it will happen again. The problem is we don't know when.