The first quarter of this year has been rough for the stock market and many people are wondering what the future holds. It’s impossible to say for sure, but there’s a chance that the current downturn could linger as the Fed raises interest rates in 2022 and 2023. If you’re concerned about your retirement savings, don’t worry – there are things you can do to protect them! In this article, we’ll discuss some steps you can take to protect your 401(k) from a market crash.
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In This Article
- 1. Assess your risk tolerance and choose your investments accordingly
- 2. Understand the investing options available in your 401(k) plan
- 3. Create a diversified portfolio
- 4. Rebalance your 401(k) plan regularly
- 5. Keep enough cash at hand for emergencies
- 6. Stay calm and don’t panic sell
- 7. Avoid high-risk investments
- 8. Use dollar-cost averaging to buy stocks during a market crash
- Bottom Line
1. Assess your risk tolerance and choose your investments accordingly
When you invest in the stock market, remember that you’re buying part of a business(es). And businesses do fail sometimes, and when they do, investors often lose some or all of their money. For this reason, the stock market is one of the riskiest investment classes.
So when you put your retirement money in a 401(k) account, your investments will certainly experience fluctuations. In some years, you’ll see spectacular gains, but in other years, you’ll suffer losses.
And so the first step to protecting your 401(k) is to understand the risks and to assess your risk tolerance.
Risk tolerance refers to an investor’s willingness to absorb a certain amount of risk. And everyone’s risk tolerance is different. On one hand, risk could mean opportunity, excitement, or a chance to make huge profits. On the other hand, risk also entails accepting the possibility of losses, the ability to tolerate market swings, and the inability to foresee what will happen next.
Your 401(k) will certainly experience fluctuations throughout your working life. In some years, will be great while in others, the results will be disappointing.
So it’s important to assess your own risk tolerance and make choices that you’re comfortable with.
If you’re not comfortable with taking risks, you may want to pay close attention to your asset allocation and diversification.
This means investing in safer options like value stocks and bonds. We’ll talk more about asset allocation and diversification in step #3.
2. Understand the investing options available in your 401(k) plan
There are approximately 15 different investment alternatives to pick from in a typical 401(k) plan.
Your 401(k) has a summary document that describes the default investments in your plan, as well as any additional investment choices available to you. The most popular options offered in 401(k) plans are target-date funds, mutual funds, index funds, and bond funds.
Normally, your contributions are automatically invested in the default fund(s) of your 401(k) plan. However, you can always change it. You can select the exact funds where your money will be invested in.
If you have an online portal for your 401(k) plan, you can research the different funds available and transfer your money as you please. If not, you’ll need to talk to the administrator of your plan about moving your assets to different investment choices.
I highly recommend choosing index funds at the beginning of your career, and changing it to a mixture of index funds and bond funds as you approach retirement. I recommend this because they have the least amount of fees. So more of your money goes into actual investing instead of going to mutual fund managers’ pockets.
3. Create a diversified portfolio
Diversifying your portfolio is the single most essential thing you can do to reduce risk.
A diversified portfolio is important because it spreads out the risk. When you invest in a variety of assets, it’s less likely that you’ll lose all your money if one of your investments tanks.
There are two different forms of diversification that every investor should practice:
The first form of diversification involves deciding on an asset allocation strategy. That’s how much of each asset class you possess, for example, stocks, bonds, and cash equivalents like money market funds.
An example of an asset allocation strategy would be having a portfolio that consists of 50% stocks and 50% bonds. If the stock market crashes, you’ll still have some money invested in bonds, which are less risky than stocks.
The next type of diversification occurs within each asset group. For instance, if stocks account for 50% of your portfolio, look for a good mix of large-cap and small-cap stocks, as well as growth and value stocks.
Another great way to diversify your stocks category is to use index funds. An index fund like the S&P500 contains the largest 500 companies in the US. Investing in an index fund that tracks the S&P500 would mean that you own a small part of each of the 500 companies. If any of them were to go bankrupt, you would only lose 0.2% of your portfolio.
You can also think of diversification as NOT putting all your eggs in one basket. When you invest in a diversified portfolio, you’re essentially saying that you’re willing to risk some money on high-risk investments, but also want to invest in low-risk investments just in case.
Read More: 5 Things to Do When the Stock Market Crashes
4. Rebalance your 401(k) plan regularly
Another important part of preserving your retirement savings against crashes is rebalancing your portfolio, or adjusting how much you have in different assets.
Over time, some investments such as stocks outperform others and become a huge part of your portfolio. It changes your asset allocation percentages thus exposing you to more risk.
Rebalancing brings the percentage of money invested in stocks and bonds back in line with your original investing plan.
To rebalance your portfolio, sell off the investments that have made too much gains that they’ve tipped your portfolio off balance.
It’s also worth remembering that rebalancing is not the same as withdrawing money out of your account. These transactions take place within your 401(k) and are not subject to immediate taxation.
5. Keep enough cash at hand for emergencies
Stock market crashes tend to coincide with economic downturns or recessions. During such times, many people lose their jobs and find themselves in a vulnerable position. They’re no longer able to cover their expenses and are forced to prematurely withdraw from their retirement accounts.
Those already retired are forced to sell out of their investments early in retirement when they lose their source of income – usually dividends or bond coupons. They run the risk of outliving their retirement funds.
So, one of the best ways to protect your 401(k) from a market crash is to keep enough cash at hand for emergencies. This will allow you to cover your costs if the stock market takes a nosedive and your investments lose value.
It’s a good idea to have 3-6 months’ worth of living expenses saved in case of an emergency. So, if you lose your job or experience some other financial hardship, you’ll have some money to fall back on.
If you’re retired, you have to be even more cautious. It’s advised to have up to 5 years’ worth of living expenses in cash or cash equivalents such as short-term bonds.
6. Stay calm and don’t panic sell
When the stock market crashes, it can be tempting to panic and sell your investments at a loss. But this is usually not the best course of action.
The best thing you can do during a stock market crash is to stay calm and not panic. This will help you make rational decisions about what to do with your investments.
If you do panic and withdraw your investments, you may end up losing more money than if you had stayed calm. The stock market always rebounds after a crash, so you could miss out on some of the growth if you sell too soon.
Instead, try to stay focused on your long-term goals. Remember that stock market crashes are temporary events, and they will eventually recover.
Read More: When Should You Sell A Stock?
7. Avoid high-risk investments
It’s important to be aware of the high-risk investments in your 401(k) account such as small-cap stocks, penny stocks, and cryptocurrencies. It’s especially important to avoid them as you get closer to retirement. These investments are more volatile than other options, and they could put your retirement savings at risk if the economy takes a turn for the worse.
Instead, focus on investing in safer options such as index funds, large-cap stocks, value stocks, and high-grade bonds or money market funds. These investments are less likely to lose value during a stock market crash, and they will help you protect your retirement savings.
8. Use dollar-cost averaging to buy stocks during a market crash
There’s a lot of money to be made during market crashes. This is because it’s when stocks are on sale.
Unfortunately, it’s the time when most investors are fearful that the market will continue to fall and so they either avoid buying more stocks or even worse, sell out of the market.
Others decide to stay on the sidelines and wait for the market to reach its lowest dip before they can buy. The problem with this strategy is that it’s impossible to know when the market has reached its lowest point. So what often happens is the market bounces back and those investors continue waiting for it to fall further. They eventually miss out on great buying opportunities.
Dollar-cost averaging is the best strategy to apply during a market crash.
It means making small purchases regularly during the entire crash. If you have saved cash that you won’t need in a long time, this is an opportunity to buy stocks at their cheapest.
So when the market falls, you buy and if it falls further, you keep buying. Even on its way back up, the prices are still quite cheap so you can keep on scooping.
When using dollar-cost averaging to buy stocks during a market crash, you’re taking advantage of the lower prices.
In this article, we’ve gone into depth trying to understand the different strategies that you can use to protect your 401(k)from a stock market crashing.
However, the most important thing you can do is to diversify your portfolio and keep some cash on hand in case of an emergency. If you are retired or nearing retirement, it’s even more imperative that you have enough cash saved for situations such as market crashes.
If you have money saved up that you won’t need in the near future, use dollar-cost averaging when buying stocks during the crash so that if prices drop further, they’ll be cheaper than before.
Remember, there’s no need to panic! Market crashes never last too long and stocks always bounce back.