MONEY

Surviving a 401(k) freak out

Question: My 401(k) is invested entirely in stocks and has dropped 30% over the last two months. Should I move my account out of stocks now, or should I wait for my account balance to go back up and then move it into bonds until the market stabilizes? I’m afraid I’m going to lose even more. Help! —Leslie, Fairfield, Connecticut

Answer: It’s natural in uncertain times like these with financial markets reeling around the globe and no one sure whether last week’s bailout package will work, that you would want to do something, anything, to stem the bleeding in your 401(k).

I mean, just about any move you make has got to be better than staying in stocks and watching your 401(k)’s balance continue to dwindle, right?

Wrong. Switching your 401(k) money into bonds or even cash for that matter may make you feel better in the short-term. But by allowing fear and panic to dictate your investing strategy, you are undermining your long-term prospects for a comfortable retirement.

So I suggest you stifle the urge to flee stocks completely and hunker down in a temporary safe haven. Instead, you need to take a deep breath, step back and assess this situation coolly and rationally.

The sky isn’t falling

The first thing you need to know is that, despite the steady drumbeat of bad news about the stock market and frozen credit markets, the U.S. economy isn’t going to disintegrate. Yes, we’re probably in or entering a recession. When we’ll come out of it, frankly, no one knows for sure. Recessions typically last about 10 months, but the length and severity of this one depends a lot on how well the bailout package works and how much the housing market continues to drag down the rest of the economy.

The point, though, is that the economy and the markets will rebound from this crisis just as we’ve recovered from the Crash of ’87, the Asian crisis of 1997, the Long-Term Capital Management debacle in 1998 and 10 recessions since World War II.

Stocks aren’t dead

The second thing you need to remember is that stocks still offer you the best shot at the long-term capital growth you’ll need to build a nest egg large enough to sustain you through retirement. I realize that notion may be a hard sell given that the stock market is down more than 20% for the year to date, and that stock returns have actually lagged those of bonds over the past 10 years. Occasional steep setbacks in stock prices are nothing new, however. And while stocks’ performance over the past 10 years has been discouraging, it’s also an anomaly.

Of the 73 rolling 10-year periods since 1926 (1926-1935, 1927-1936, etc.), stocks have outgained bonds 85% of the time. And if you extend the period to 20 years, it’s a near clean sweep with stocks winning 98% of the time.

There’s no assurance that the future will reprise the past. Then again, the case for stocks is even stronger if you invest in them when they’re selling at prices well below their previous highs, as is the case today.

As for your plan to get out of stocks now with the idea of moving back in when things stabilize, I don’t recommend it. Stocks typically lead an economic recovery. So by the time you feel more comfortable about investing, the market may have already begun to rally. And if you aren’t there for the initial stages of a stock-market rebound, you may be giving up some big returns.

When the market exploded from its low in the 1982 recession, for example, it gained 59% over the next 12 months. But 70% of that return – fully 40 percentage points – came in the first six months. If you’d been sitting in cash those six months, you would have earned just 4%. And even if you’d been able to react quickly enough to move to stocks at that point – a debatable assumption since it’s hard to know whether an upturn is the real deal or a bear-market rally that will fizzle – you would have ended up with only a 19% gain for those 12 months instead of 59%.

Fix your mix

Alas, neither I nor anyone else can guarantee when the market will recover or how quickly it will take off. But if you want to participate in the rebound as well as stocks’ superior long-term returns, you want your 401(k) account to be positioned to take advantage of it.

The way to do that is to set a mix of stocks and bonds based on how much risk you’re comfortable taking and when you plan to retire. The younger you are, the more you should tilt the mix in your 401(k) toward stocks. You don’t have to be so concerned about stock-market setbacks – even particularly frightening ones like yesterday’s – since you’ve got plenty of time to bounce back.

There’s no ideal mix that’s right for everyone, but generally if you’re in your 20s or 30s and retirement is a good 30 or more years away, you should probably have between 80% and 90% of your retirement savings invested in a diversified group of stock funds and the rest in less volatile options like bond funds and/or stable-value funds.

As you get older and have less time to recoup stock market losses, you want to gradually scale back the percentage of your 401(k) that you devote to equities, although you still need the growth potential of stocks. So by the time you’re in your 50s, you still probably want to have 70% or so of your retirement portfolio in stocks and perhaps 60% or so by the time you’re 60.

As a guide to setting the stocks-bond mix for your 401(k), you might check out a target-date retirement fund with a year that corresponds to the year you plan to retire (2020, 2030, 2040, whatever). Or you can create your own stocks-bonds mix with our Asset Allocator tool.

I think investing 100% of your 401(k) in stocks is being a bit too aggressive for nearly all investors. It’s the kind of approach people adopt when the market is flying high and downturns seem like only remote possibilities – and they then come to regret when the harsh reality of a bear market sets in.

What you don’t want to do, though, is get so freaked out by the current crisis that you dump stocks altogether and huddle in your plan’s most conservative options. That may keep your 401(k) balance from declining now. But you’ll likely be relegating yourself to subpar long-term returns and setting yourself up for a more devastating setback later in life – entering retirement with a nest egg that’s too small to support you.

More on retirement

Your browser, Internet Explorer 8 or below, is out of date. It has known security flaws and may not display all features of this and other websites.

Learn how to update your browser
Follow

Get every new post delivered to your Inbox.

Join 45,780 other followers