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Should Tough Market Conditions Influence Investing?

"Our son is four years away from college. We are in a quandary about how to invest money that will be needed within a few years. Many people are facing the same dilemma, including those who are nearing retirement. When does a declining market change a savings and investing strategy, if ever? Industry advice is usually to hold the line, to be patient. But are there exceptions to that, and what are they?"
–Chris, Princeton, N.J.
Deciding how to invest your money is a function of two factors: when you're first going to need to withdraw the money, and how long you're going to need the money to last. If your money is diversified according to those two key criteria, tough market conditions are already taken into account. If you will not need the money for many years, it's reasonable to expect (although certainly not a certainty) that any declines will be more than offset later.
On the other hand, if you're going to need some or all of your money within a few years, whether the market is thriving or diving, you can’t afford to risk that money by investing a large portion of it in stocks. So I agree with the wisdom that says your investment plan should not deviate based upon current market conditions if—and this is a big IF—you are already diversified appropriately. But if you've got most of the money you’re going to need soon invested in stocks, lighten up on stocks now.
Likewise, if you’ve got most of your very-long-term savings in bonds or cash, you risk losing ground to inflation even though cash and bond investments may seem especially attractive right now.
Sometimes the stock market will suffer big declines, as it did in September and early October 2008. The temptation to throw in the towel and sell everything can seem overwhelming, but doing this would probably be a big mistake. When the stock market rebounds from big losses, it usually does so very quickly, long before those who abandoned all or most of their stock investments decide to get back in and reinvest.
College Savers
Chris, your college-savings situation is a good illustration of the variables I mentioned earlier. You'll need to make the first withdrawal in four years, and the money needs to last four years after that. This is a fairly short period of time, which argues for a conservative approach to investing the college funds.
A Lesson From the Professionals
I usually advise parents who have 529 plans for college savings to use the "age based" investment option. This type of fund automatically adjusts the investment allocation based upon the amount of time before the money will be used and how long the money will need to last (both values derived from the age of the young scholar). Here is an example of the way some professionals who manage 529-plan investments change the allocation over time:
Home Buyers
What if you were hoping to buy a home four years from now? In this instance, invest the money very conservatively—primarily in short-term bond funds or cash—since there probably isn’t enough time to make up for any major decline in stocks. This home buyer's situation is much like that of a student about to enter college, and the allocations in the table to the left would apply.
The Pre-retiree
Contrast the home buyer's project above with a very common situation: getting near retirement. Assume that someone is four years from retiring at age 65. In this case, the money will need to last for 25 years or more.
Retirement is a considerably different situation than the college saver's and the homebuyer's. Many pre-retirees erroneously believe they should begin to invest very conservatively. After all, they're going to need to start withdrawing the money soon, but their nest egg will have to last for decades. They'll need to draw income from their investments to pay bills, but they will need their savings to grow in order to keep up with rising living costs throughout their retirement years.
The 60/40 Solution
Still in a quandary about what to do? Here’s another suggestion that I and many others who study these matters have long recommended:  If your money is going to have to last for at least a decade (as it will for pre-retirees), an allocation of 60 percent stocks or stock mutual funds and 40 percent bonds or bond funds and cash is considered an excellent way to balance the sound investment returns offered by stocks while reducing overall risk with a healthy serving of bonds and cash. An allocation of 60 percent stocks and 40 percent bonds is considered a classically balanced investment portfolio. "Balanced" mutual funds usually allocate the money they hold in the same proportions, and they have great popularity among investors. The 700-plus balanced funds that are available manage more than $500 billion for their investors.
All the information presented on is for educational and resource purposes only. We suggest that you consult with your financial or tax adviser with regard to your individual situation. Use of the information contained in this Web site is at the sole choice and risk of the reader. 

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