For millions of Americans, their 401(K) is the foundation of their retirement plans. Many are watching in horror as nearly $1.4 trillion is being erased from their accounts amid the worst start in the stock market since 1939. Many analysts say that the worst may not be over. It may be no consolation for plan participants right now, but we’ve been here before, and, as it has done for more than one hundred years, the stock market has been resilient. Ultimately, the most significant risk to 401(k) investors is not stock market downturns; it’s how they react to them.
You can do several things to protect your 401(k) from a stock market crash. The one thing you absolutely should not do is panic. Your 401(k) may be losing value, but you won’t realize any losses unless you sell. Instead, it’s essential to gain some perspective and stay focused on your long-term goals. Remember, you’re not investing for today; you’re investing for future returns.
What is a Stock Market Crash, and How Can it Impact My 401k?
Stock market crashes (i.e. decrease of more than 20% from a peak) occur more often than people would like. A stock market crash in the S&P 500 has occurred about every six years, on average, over the last 71 years. Though that doesn’t seem very frequent, their aftereffects and the time it can take to recover can last a couple of years.
Stock market crashes are characterized by severe and rapid stock price declines that tend to occur without notice. The stock market is deemed to have crashed when it falls more than 20% from its 52-week high in just a few days.
Why Do Stock Market Crashes Happen?
Panic selling is the main contributor to stock market crashes. It is sometimes triggered by an unexpected market or economic event, such as the COVID pandemic, but it can also result from overexuberant buying leading to untenably high stock valuations. When stock prices far exceed the intrinsic worth of companies based on earnings, investors will start selling them. The selling could be gradual initially but then gain momentum when programmed trading kicks in. When retail investors finally catch on, panic selling sets in, but only after stock prices have fallen drastically.
It’s important to remember that market downturns are a natural part of the overall stock market cycle. They occur with some regularity because they are actually good for the market. They’re called “market corrections” because they correct imbalances and inefficiencies in the market, rooting out excesses and returning stock prices to more reasonable valuations. Stock market crashes are an extreme version of a market correction, but they achieve the same thing.
What Does a Stock Market Crash Mean for My 401k?
The question really should be what a stock market crash means for your retirement. While it’s painful to watch the value of your 401(k) plan decline in a market crash, your more important concern should be what the value will be when you’re ready to retire.
If you’re young, with 20 to 30 years to go before retirement, a stock market crash is likely to show as a tiny blip in the long-term performance of your 401(k). Investors who rode out the market crashes of 2001, 2008, 2018, and 2020 have earned historic returns.
Even if your time horizon is 10 or 15 years, your 401(k) has plenty of time to work through a couple of market cycles, allowing the market to absorb several down periods as it forges to new highs.
A stock market crash can be more impactful if you’re within five to 10 years of retirement. The question becomes whether you are better off remaining in stocks or should you move your money to lower-risk investments to preserve your capital. The challenge is if you sell your stocks, you will be permanently locking in losses that may be difficult to recover.
Over time, your best opportunity to recover from a down market is to remain in stocks. However, you may want to make some adjustments to your portfolio to account for a shorter time horizon. Some of those adjustments are discussed later.
How Can I Prevent 401(k) Losses?
The only way to prevent 401(k) losses is to park your money in cash investments. But that also means you are not likely to achieve your retirement goals. Investing in equities is one of the best ways to generate the kind of returns needed over the long term. Though the stock market has historically trended up, there have been and always will be brief periods of retrenchment. While you can’t prevent the periodic declines in 401(k) values, you can take steps to mitigate them or reduce the downside risks.
Don’t do anything rash
When humans feel fear, the primal instinct is to do something—anything—to remove themselves from the situation. Fear is the primary driver of panic selling as a way to prevent further losses. The problem is selling into a steep market decline guarantees you’ll have losses, which will be very difficult to recover. Instead, take a moment to assess your situation and refocus on your long-term goals.
With the current market decline, you may find that you are not actually worse off than before the pandemic. The recent losses have merely wiped out the extraordinary gains the market produced between April 2020 and the end of 2021. Take time to review your long-term goals and see where you are in relation to them.
Revisit your asset allocation
If you have a long-term investment strategy, making wholesale changes to your asset allocation is not recommended. Instead, you should consider adjustments around the edge of your portfolio. Diversification is the key to reducing portfolio volatility. For example, you might consider increasing your exposure to international stock funds or ETFs for more diversification. You can increase stability by adding a blue-chip dividend stock ETF. Diversification is the key to reducing portfolio volatility.
Rebalance your portfolio
Typically, big market moves, whether a rally or a steep decline, can cause your asset allocation to get out of whack to where it no longer reflects your objectives or risk tolerance. Use these opportunities to rebalance your portfolio by selling appreciated securities and buying securities that have lost value. Doing so increases your upside potential when the market recovers.
Don’t stop investing
The goal of 401(k) investing is to accumulate as many shares as possible so that, when the market continues its long-term advance, you have more shares increasing in value. As counterintuitive as it might seem, it’s to your advantage to continue to invest in equities as the market declines. As the stock prices fall, your monthly contribution can buy an increasing number of shares. Assuming the stock market continues to rise over time, as it has since its inception, you’ll have a larger number of shares increasing in value, and your current share price will always be higher than your average cost basis. The strategy is called dollar-cost-averaging.
Stop scouring your account statement
Investors who are more focused on the short-term fluctuations of the market than their long-term objectives tend to act impulsively and make costly investment decisions. What happens today or tomorrow in the stock market will have zero impact on your long-term investment performance. If you have a time horizon of ten years or more, ignore the media noise and stay focused on your long-term investment plan.
If you’re less than ten years from retirement
For time horizons of less than ten years, a steep stock market decline could affect how much you can safely withdraw for income. While you should maintain some exposure to equities to help your portfolio value recover and grow throughout retirement, you should consider increasing your allocation to cash investments or a short-term bond fund. By accumulating sufficient cash—about two to three years’ worth of living expenses—you can avoid having to sell securities at a loss should you need to start drawing down assets during a stock market decline.
Keep a Historical Perspective
Watching your 401(k) values fall by 10% or 20% can be disconcerting. However, keeping a historical perspective on what is happening can be reassuring. It’s important to remember that market declines are built into the stock market’s DNA. Consider the history of market pullbacks:
Though more significant declines of 30% or more happen less frequently, two have occurred since 2000.
The critical takeaway is that regardless of the severity and length of a market decline, the market has always come back more robust with a more enduring advance. Investors who sell into a market decline often miss most of the subsequent recovery and advance, which can devastate their long-term returns.
The critical lesson from this history is that, following every market decline since 1926, a stronger and more enduring market advance has taken stock prices to new highs.
Stay Close to Your Financial Advisor
Severe market declines can be harrowing, but you don’t have to go it alone. It’s times like these when working with a financial advisor that can bring calm and reassurance. Your financial advisor can help you with any of the strategies discussed here, including portfolio rebalancing, adjusting your allocation, and assessing where you stand in relation to your retirement goals. More importantly, a good financial advisor can prevent you from making costly behavioral mistakes that can be devastating for your financial future.
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