How the European crisis affects your portfolio

(Money Magazine) -- Question: With all the discussion about Greece, Portugal, Spain, etc., I'm concerned about how failing economies in Europe will affect my retirement savings. My portfolio is diverse, but I'm still worried that I am going to take another major hit. I am nine years from a potential retirement. Should I be concerned? --Gary, Buffalo, New York

Answer: Concerned? Sure.

• Facebook
• Digg
• Twitter
• Buzz Up!
• Email
• Print
• Comment on this story

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

One look at how markets around the world have been reeling lately tells you that, unlike Vegas, what goes on in Greece, doesn't stay in Greece. The same goes for Portugal, Spain, Europe in general and, for that matter, any economy of decent size. That's just the way our interconnected world works.

But as frightening as the prospect of problems abroad wreaking havoc at home may be, it would be a big mistake to get so freaked out that you start making moves you might regret later on.

So how should someone invest for retirement in a world where, to re-phrase 17th century English poet John Donne's famous line, no country is an island, and the woes of one nation can send markets tumbling in another?

The first thing you want to do is keep your cool. Don't overreact. As the Greek debt drama and its repercussions unfold, you can easily get the impression that we're on the verge of Armageddon, especially if you watch cable TV's fevered coverage of the financial markets' gyrations.

But the fact is that it's difficult to tell whether the jitters are going to send stock prices down for a short time or trigger a truly significant long-term decline.

Given that uncertainty, you have two basic choices. One is to take dramatic action to protect yourself in event we get the kind of market rout you fear. I call this the "Don't just stand there, do something!" approach.

Doing something might involve selling off European stocks, as some advisers have suggested. Or it might mean getting out of stocks entirely and moving your savings into traditional ports in an economic storm, such as Treasury bills or gold.

I'm not an advocate of this approach. For one thing, getting the timing right is tough. By selling now are you being smart by getting out in time to sidestep a steeper decline? Or stupid by selling after most of the damage has already been done? It's impossible to tell, although we do know this much: if you really had a methodology for foreseeing the future, why didn't you get out of stocks back in late April before they began their 12% slide through yesterday's close?

Another problem I have with the activist approach is that in avoiding one risk -- a setback in the market -- you may open up yourself to another. Your money will be safe in Treasury bills, but they're yielding less than 0.5%, which means the value of your investments won't be keeping up with inflation. Gold, on the other hand, has racked up stellar returns over the past few years. But now that it's close to its all-time peak, you can't help but wonder whether it too might be vulnerable to a correction.

If you think you're able to predict how the European economies will fare and also how different investments around the globe are going to react -- and then buy the right ones at advantageous prices -- more power to you. And don't forget: you'll also need to know when it's time to get out of those investments and into whatever ones are best positioned to deal with the next crisis or opportunity down the road. In short, you're going to need a steady supply of foresight.

The second approach you can take -- and this is the one that I think does make sense -- is to admit that there are too many variables and cross-currents in a global economy for you to foresee.

Once you acknowledge that, you can begin dealing with risk in what I think is a more rational, disciplined and systematic way -- namely, creating a diversified portfolio that can weather a lot of different scenarios. Diversifying can't totally immunize you from market mayhem or guarantee you the highest return. But it can provide a decent measure of downside protection while giving you a shot at the long-term growth you'll need to maintain the purchasing power of your savings in the face of inflation.

The core of such a portfolio is a mix of of stocks, bonds and cash. Generally, when you're just starting out in your career, stocks should make up the bulk of your portfolio, say, 80% or more, because at that point in life you're likely looking to grow your savings more than preserve them. As you get older and especially as you near retirement, you want to shift the blend increasingly toward more stable investments, i.e., bonds and cash. That's because you have less time to recover from big market setbacks later in your career.

You can argue about what that mix of stocks, bonds and cash should look like, but the target-date retirement funds on our Money 70 list of recommended funds provide a pretty decent guide. In your case, with about nine years to go until retirement, you could use Vanguard's Target Retirement 2020 or T. Rowe Price's Retirement 2020 fund as a guide.

Both include a widely diversified mix of domestic and international stocks as well as bonds, although T. Rowe Price's fund is slightly more aggressive with about 73% in stocks vs. 67% for Vanguard. By 2020, the Vanguard fund will have morphed to about 50% in stocks, while the T. Rowe fund will have gotten to about 55% in stocks.

You can always play it safer by putting other money in cash or bonds, of course. Just remember that while doing so may make you less exposed to market meltdowns and such, you'll also give up some potential for growth. To see how the trade-off between risk and return works, you can check out Morningstar's Asset Allocator tool.

The bottom line: it's natural to be concerned by wild swings in stock prices. And you definitely want to be realistic about stocks' potential for losses and factor equities' volatility into your investing strategy.

But the right way to do that is to be sure your portfolio is truly diversified and reflects a reasonable balance of risk and return, not engage in an investment guessing game.

Need to figure out your financial future? Upload your video or send us an email and tell us why your family needs a money makeover and you could be profiled in an upcoming story in Money Magazine.