During a bull market (i.e., a period of steadily increasing share prices), it's easy to forget that good times don't last forever. But during a bear market (a period of decreasing share prices), every time your statement arrives it's all too clear that your hard-earned dollars are evaporating and your hopes of a financially secure retirement could be as well. What should you do when times get tough? These four steps will help you bear-proof your 401(k) plan.
- Markets go down as well as up, so crafting a solid investment plan to reach your retirement goals is key.
- Be sure that your 401(k) investments are diversified across asset classes to minimize risk.
- When markets do fall, don't sell in a panic. Instead, consider buying at discount prices.
- Try to avoid making 401(k) withdrawals early, as you will incur taxes on the withdrawal in addition to a 10% penalty.
Set Your Goals
Stumbling through bad times without a strategy makes a shaky situation worse. If you don't know how much money you need to achieve your retirement goals, you won't be able to accurately assess the damage when the markets take a tumble.
Investing isn't about trying to pick a hot stock or mutual fund and riding it to the moon. You should have a goal and a plan to reach said goal. That goal should include a time frame for achievement and a backup plan in case things don't go as well as expected.
Plan Your Asset Allocation
After you've determined how much money you will need, the next step is to figure out how your investments can help you get there.
In this regard, asset allocation is the key. Your money should be divided among a variety of investments that are more aggressive or more conservative depending on your personal risk tolerance. In a bull market, a conservative investment like a bond fund seems awfully dull. In a bear market, it can be a life-saver. Whatever the markets are doing today or tomorrow, diversification can help reduce your risk and increase your overall returns.
This is particularly important if your employer's stock makes up a big chunk of your retirement portfolio. If the stock market is in trouble, having too many eggs in one basket could scramble your returns. Limiting employer stock to no more than 10% of your holdings is a good rule of thumb.
Bulls and Bears
Some have argued that "bull" markets are so-named because bulls thrust their horns in an upward direction, reflecting the increasing values and rising stock prices experienced during these times. In contrast, a "bear" market is so-named because bears swing their claws downward, reflecting the decreasing values and falling share prices experienced during these times.
A down market is not the time to make radical changes. Whatever happens, don't blindly sell your equity funds and move all of the remaining assets into a money market fund. The urge to flee to safety can be nearly overpowering, but keep in mind that your current losses are all on paper. That is unless you sell now and lock in those losses. If retirement is still years away, you have time to let your portfolio recover.
What should you do during a bear market? If you had a long-term investment strategy in place before the markets took a dive, it's time to revisit your plan. Are your goals still the same? Is your retirement still years in the future? If the particulars of your situation haven't changed, this is no time to change your overall investment strategy. Stock prices rise and fall. Just because they have fallen doesn't mean your strategy should change.
Remember, if you take withdrawals from your 401(k) account, you will be hit with a 10% penalty if you are under age 59½, plus owe taxes on the withdrawal. That can be a real financial impact, especially in hard times. Moreover, you'd likely be selling at a market bottom, when prices are near their lowest, further hindering your financial outlook for the future.
When the markets drop, lots of people want to sell and get out. This is illogical behavior driven by panic. Instead, think of stocks at low prices as being on sale.
If you saw that something you wanted—a car, a computer, a resort weekend, etc.—was on sale at a huge discount, you'd probably snap it up in a minute. Investments are no different. Just as stock prices don't rise forever, they don't fall forever either. If you bought when prices were higher than they are today, then selling low is not the key to investment success.
Over the long term, the stock market has generally gone up. Use that trend to your advantage.
Buying low is a better idea. Think about those bear-market prices. Stocks are on sale! Buy them.
If you can afford to invest a greater percentage of your income, now is the time to increase contributions to your 401(k) plan. If your employer offers a matching contribution, raise your contribution at least to the level that will get you the full match. It's a guaranteed return on your investment and will help make up for some of the losses caused by a bear market.
The Bottom Line
Stock markets and economic cycles can hit bumps every now and then, becoming volatile and even scary at times. Remember, over the long term, the stock market historically has gone up. This trend is your friend. Use it to your advantage. Buy assets when they are on sale and when people are panicking. Stay rational and level-headed. Even the worst economic crises eventually resolve and rebound.
If you're young enough, you probably have several years if not decades ahead of you to retire. Raiding your retirement fund early or under-investing in stocks over the long run can be detrimental to your overall finances. Stay the course, if you can.