04/28/2014 09:58 am ET Updated Jun 28, 2014

Bulls, Pigs, and Chickens Target the Market

You don't have to be a bull or a bear to get into the stock market debate. In fact, I've always recommended having some "chicken" money on the sidelines, not only for liquidity and protection against loss, but because the very fact that you have money in a safe place allows you the discipline to stick to a long-term plan of stock market investment and exposure.

But don't be too "piggish" about stocks, because you remember the old saying: "Pigs get fat and hogs get slaughtered!"

This barnyard argument comes into play when the truly important and sophisticated question of "asset allocation" is discussed. The idea is to find an appropriate balance of risk, reward, and safety -- based not only on your emotional comfort, and your own financial situation, but on historic probabilities.

Is there ever a time when you should be completely out of the stock market? Sure, you should be out when the market is going down! But you'll only know that in hindsight!

Even the most sophisticated professional traders, even the best of hedge fund managers who have all sorts of tools to mitigate against loss, even the best computer programs -- can't create a consistent track record of having only winning trades. Few manage to beat the market consistently over the long run.

But why try to beat the market, when over the long run -- periods of at least 20 years -- it has always turned in a positive performance, even adjusted for inflation? Those statistics come from the Ibbotson market historians, whose statistics show that over every 20 year period since 1926, a diversified portfolio of large company stocks with dividends reinvested has had an average annual return of around 10 percent.

So why worry if you can reasonably expect your diversified portfolio of stocks to beat inflation over the long run? Well, that success depends on two key ingredients: your time horizon and your own self-discipline in sticking to keeping an agreed upon portion of your retirement capital in stocks, no matter how scary the market.

The Target Date Fund Solution

The issue of stock market exposure is now making headlines, because so many 40l(k) plan investors have put their money into Target Date funds, which are aimed at managing risk and diversifying retirement portfolios. But even at "retirement age" those funds typically have at least 50 percent of the assets in stocks, and some target date funds have a higher percentage in stocks at the target date.

The reason is simple: You may retire at age 65, but still likely have a 20 year time horizon, during which you must protect the buying power of your retirement account against the ravages of inflation. Remember, even with "only" 3 percent annual inflation, your money will lose half its buying power in 25 years!

And there's another good reason that so many people are in Target Date funds: they don't feel themselves competent to pick out a portfolio of mutual funds from all those offered in their retirement plan. The Target Date funds look like the "easiest" option, because the fund management promises to adjust investments within the funds to reduce risk as retirement age nears.

Plus, plan sponsors highlight those Target Date funds, because the Pension Protection Act of 2006 allowed plan sponsors to "default" investments into this type of fund. The reasoning, back then, was that too many employees were just sticking to the safe money market type options within the plans, a choice that practically guaranteed them a loss over the long run, because of the impacts of inflation and taxation on withdrawal. So Target Date funds became a "safe harbor," which the plan fiduciaries could justify as an appropriate destination for retirement assets.

Target Date Safety

Of course, you can easily recognize the potential problem: what if you need to withdraw funds for retirement, just as the market is crashing? That's where the discipline comes in. First, you need the discipline to work out a plan of regular withdrawals from the target date fund, a plan designed to make your assets last your lifetime.

That's not a question of "averages." In fact, it requires some sophisticated computer modeling using a "monte carlo" analysis program that takes historic ranges of stock performance into its projections, to give you a suggested monthly withdrawal amount. Most major mutual funds and some financial planners will do this kind of modeling for you to create an appropriate program of both investment choices and withdrawals.

And then yes, some withdrawals are bound to be made near the bottom of the market -- while others are made on the way up, or down. It's a fact, so it shouldn't create stress. You're not trying to pick tops or bottoms -- just to stick to your well-made plan of making your money last as long as you do!

Think back to spring, 2009. Sure, some regularly planned withdrawals were made near the market bottom. But because of the asset allocation feature, some of the money withdrawn for retirement income came from the cash portion of the Target Date fund. The rest of the money remained partially invested in stocks, allowing for recovery of the fund's assets.

And that brings us to the second discipline of successful stock market investing: self-discipline. Many of those who saw their retirement funds going "down the drain" in 2009 rushed to get out of all their stock market exposure, much to their regret as they missed the climb back from Dow 6700 to now well over 15,000.

Sadly, experience is the best -- and most expensive -- teacher.

And now it's your turn again to discover where in the barnyard of investment animals you fit, as the stock market makes new highs. How much exposure to stocks is "enough" at your age and stage of life? The time to think about that is not when you're in a panic, but when you can calmly discuss the issue with your trusted advisor in the context of your long term goals and needs. That's when you can easily move more of your money to money market funds and short-term CDs.

There's nothing wrong with being chicken. In fact, once you're retired and unable to add more contributions, your percentage of "chicken money" might grow larger as a portion of your assets. But you still need some growth that stocks can provide over the longer run. And that's The Savage Truth.