Biggest Threat To Your Retirement: A Short Memory

(MoneyWatch)  Some are saying the recession is over and the worst is behind us. But with the financial markets, the worst is never behind you. Forgetting about risk is the biggest threat to your retirement security. And you're most likely to forget about it during the good times.

I'm always surprised at how quickly investor perception about risk changes in the markets. The minute we have a short burst of good returns, everybody wants to be a stock jockey again.

Good Times Magnify Risk. But remember, the seeds of this recent crisis were sown during the good times, not during the bad times. That was also the case with the tech bubble. So when the economy gets better, you can be sure that the seeds of the next unwinding are being planted somewhere in the system. I know that's an uncomfortable thought, but you just have to plan for it.

• In one form or another, excessive optimism is usually the cause of each financial crisis. It's the good times that encourage people to take on too much risk, take on too much debt and overpay for assets. That leads to bubbles and then declines.

Appropriate Optimism. Now, I don't want to be a wet blanket. There's nothing wrong with being optimistic about your job, your income and your prospects for greater wealth. You should be optimistic on an individual level and for the overall economy because things generally get better.

• But don't confuse optimism about your earnings potential and the capacity for the economy to grow with optimism about how the financial markets work. They are two different things. When it comes to managing your money, a healthy dose of caution is important.
• The financial markets have been subject to boom and bust cycles, and it's likely this pattern will play out again in the future.

Allocation. That's why financial advisers often tell people that the most important thing to get right is your allocation between stocks (risky) and high quality bonds (safer) assets. But the allocation is where most people make their biggest mistakes. The key is to set an allocation you're comfortable with during good times and bad.

• When times are good, keep your discipline and resist increasing your allocation to risky assets. If you remember your history, you know that the good times are probably planting the seeds of the next unwinding.
• But by the same token, when times are bad, don't panic. By having sufficient safe assets in your portfolio, you should have the confidence to wait it out. When the system corrects itself, your risky assets should grow again.

Bottom line. In the last two years, you've gotten a lifetime's worth of education about financial risk. Don't forget it.

As with all financial matters, consult your individual financial adviser prior to making any financial decisions.