It’s hard to fight that sinking feeling when you check your 401(k) in a down market. As the stock market heads south, your 401(k)-account balance starts shrinking. And while there’s no way for investors who own stocks and bonds to avoid short-term losses when market volatility strikes, there are plenty of ways to buffer your portfolio from the brunt of the market storm and keep your retirement savings plan on track.
What you don’t want to do when stock prices go into freefall is push the panic button and make hasty investment decisions that could do more harm than good to your nest egg.
“What investors should do is remind themselves that they should not allow their emotions to be their portfolios’ worst enemy,” says Sam Stovall, chief investment strategist at CFRA Research.
Investors, of course, got a big scare in early August when a weaker-than-expected number on job creation put Wall Street on recession watch. The S&P 500, a gauge of the broader U.S. stock market, suffered an 8.5% pullback. And the Nasdaq composite, an index loaded with large-cap technology stocks, fell into correction territory with a drop of 13.1% from its early July high.
The problem with getting spooked by market drops is that they aren’t that unusual and don’t last too long. “Market downturns are normal; they’re going to happen,” says Catherine Irby Arnold of U.S. Bank Private Wealth Management. In fact, so-called market “pullbacks,” or drops of 5% to 9.99%, have occurred three times per year on average since the 1930s, according to BofA Global Research. And “corrections,” or declines ranging from 10% to 19.99%, aren’t really that uncommon either, despite the fear and angst they cause. A correction like the one suffered by the Nasdaq from its July 10 closing high through its Aug. 7 low, typically occurs once a year, BofA says. And, fortunately, dreaded bear markets, or scarier drops of 20% or more, occur even less frequently.
401(k) in a down market? Don't panic.
What investors must wrap their heads around to keep their anxiety and fear in check — and avoid the costly mistake of selling at the bottom in fear and missing the subsequent recovery — is the fact that the market tends to recover more quickly than people might think. We’ve had 100 (declines ranging from pullbacks to bear markets) since World War II, according to CFRA Research. “But the amazing thing is the speed it takes to get back to break even,” says Stovall. On average, it has taken just 46 days, or just a month and a half, for the S&P 500 to recover fully from pullbacks, according to CFRA. And the market has recouped its losses after the 24 corrections since World War II in a tad less than four months.
Garden variety bear markets, or drops of 20% to 40%, take a bit longer to recover from, averaging a little more than five months. The takeaway: it’s a mistake to sell into a downturn. You’re better off buying and holding so you don’t miss the rebound.
Here are four ways to cushion your nest egg from market declines.
1. Have cash at the ready
Market declines cause the most damage to nest eggs when savers are forced to yank money out of their tax-deferred retirement accounts when stock and other asset prices are depressed. When you do that, you end up having to sell more shares to raise the cash you need, and you also miss out on the growth of your 401(k) holdings once the market recovers. That’s when having a well-funded emergency fund comes in handy. “You absolutely do not want to have to use your 401(k) as your emergency fund,” says Arnold. “Having cash on hand at all times is a way to smooth out things and avoid having to tap your retirement assets when they are down.
Arnold reminds 401(k) savers that their retirement savings account is a long-term investment. For a young worker in their mid-20s, that means 40 years to both grow their wealth and, more important, plenty of years to recoup losses in any market storm. “That money is going to sit there for a while,” says Arnold, adding that it’s best to review your 401(k)-account balance on a quarterly or annual basis and not worry about short-term swings. Of course, savers in or close to retirement should take a more defensive posture to avoid huge market swings that could throw a financial plan off course.
2. Don't put all of your dollars in one basket
Diversification, or holding a healthy mix of stocks and bonds in your 401(k) or IRA, is a savior when markets turn rocky. Having all your money tied up in say, a high-octane technology sector fund or a hot stock like Nvidia, is great on the upside, but the ride will be scary on the downside.
It’s better to own broadly diversified mutual funds or index funds that track a broad basket of stocks, such as the S&P 500. The fixed-income portion of your portfolio, which consists of bonds, money markets, CDs, and other cash equivalents, will act as a downside buffer against a steep stock market decline. “At the end of the day, the best thing you can do to position yourself to weather a market downturn is to be very diversified among asset classes based on your risk tolerance and how close you are to retirement,” says Arnold.
Divvying up your portfolio using rules of thumb, such as limiting your stock exposure to 110 minus your age, will boost your chances of living through a bear market unscathed, even if you’re in your 50s and 60s. “So, if you’re 40, that means 70% of your 401(k) is in equities,” says Stovall. “But if you’re 60, you have just half your money in stocks.” 401(k) plan participants who don’t have the time or savvy to construct their own 401(k) portfolio can invest in a target-date fund, which is professionally managed and determines and regulates the mix of stocks and bonds in the fund by your retirement date, Stovall adds.
3. Invest in dividend-paying stocks
Need income in retirement? Well, a stock market swoon isn’t the best thing for the value of the stocks you own. But it won’t impact the stream of income you earn from stock dividends, says Stovall. “If you’re somebody who needs to live on the income from your investments, well, unless the company starts slashing their dividend, it doesn’t really matter what the share price of the stock is because you are paid on the number of shares that you own,” says Stovall. “Your income stream remains unaffected.”
4. Have dry powder to scoop up bargains
Market downturns don’t always have to be a bummer. When stock prices are down, it’s an opportunity to buy shares when they’re cheaper and benefit from their recoveries over the long haul. “Downturns should be welcomed because you know you’re going to be buying more shares when prices are depressed,” says Arnold.
This buy-the-dip strategy can be executed using available cash, rebalancing your portfolio to keep your stock and bond weightings intact, or simply dollar-cost averaging into the market as you always do with steady contributions into your 401(k) each pay period. “If you can put more money into the stock market after it’s down 10%, that’s going to be beneficial to you in the long run,” says Arnold.
So, if you shot yourself in the foot when the market tanked, do things differently next time. In short, learn from your mistakes.
“If you’re brave enough to go back and look at how you reacted to the market at certain times, map things out, and maybe do the opposite next time,” says Arnold. So, if you sold at the low in early August, next time you buy the dip and get stocks on sale. Every smart move in a down market can add up to a better chance of enjoying a secure retirement.
