The U.S. officially entered a recession back in February, according to the National Bureau of Economic Research, and the economy doesn't seem to be bouncing back just yet. Gross domestic product (GDP) fell by nearly 33% in the second quarter of this year, the Commerce Department revealed, which is the largest drop in U.S. history.
If the COVID-19 pandemic continues to take a toll on businesses, it could also affect the stock market. Recessions don't always equate to stock market downturns; in fact, the stock market has been surging in recent months. However, the market is still volatile, and another downturn could be on the way if the economy continues to worsen.
Protecting your savings against a market crash
A potential stock market downturn could wreak havoc on your retirement savings, so it's a good idea to prepare your investments the best you can. Nobody can predict if or when a market crash will occur, but you can take steps to ensure your investments weather the storm.
Index funds are a wise choice if you're concerned about a market downturn. These investments are comprised of dozens or even hundreds of different stocks, bonds, or other securities, and they track certain market indexes -- such as the S&P 500 or Dow Jones Industrial Average.
Investing in an index fund provides instant diversification, which is a smart move if a market downturn is looming. By spreading your money across hundreds of different stocks, your investments are more protected if a few of the companies in your portfolio take a turn for the worse.
There are a wide variety of index funds available, and they're not all created equal. Some funds are riskier than others, and these three choices are among the safest during times of uncertainty.
1. S&P 500 index funds
Like the name suggests, S&P 500 index funds track the S&P 500. In other words, you're investing in all the companies that make up the index.
The S&P includes 500 of the largest companies in the U.S., and these behemoth corporations are likely to survive even the toughest economic conditions. That means when you invest in an S&P 500 index fund, you're investing in hundreds of rock-solid companies that have a strong chance of surviving a market crash.
2. Total stock market index funds
Total stock market index funds are similar to S&P 500 index funds but tend to be broader. They track indexes such as the Russell 3000 Index or the Wilshire 5000 Total Market Index, which contain thousands of diverse companies and are considered benchmarks of the entire U.S. stock market.
Because total stock market index funds track, well, the total stock market, they're more likely to bounce back after a market downturn. You're essentially investing in a small slice of the stock market as a whole, and the market has always bounced back after every crash it's ever experienced. Your investments may take a hit in the short term, but it's extremely likely they'll recover.
3. Bond index funds
Most index funds track stocks, but some only track bonds. Bond index funds track indexes such as the Barclays Capital U.S. Aggregate Bond Index, which measures the performance of U.S.-traded and foreign bonds.
In general, bonds tend to be less risky than stocks. So by investing in a bond index fund, you're less likely to see your investments plummet if the market crashes.
However, bonds carry different risks. One is that they're sensitive to interest rates, so if rates rise, their value can drop sharply. Also, they can sometimes be too conservative. They generally have a much lower rate of return than stocks, so there's typically less opportunity for growth -- which can make it harder to build a robust retirement fund.
Balancing risk and reward
Investing in index funds can be a smart way to limit your risk and protect your retirement savings, but it's important to strike a balance between risk and reward. When you're younger and still have decades to go before retirement, you can afford to invest more aggressively in stocks. But as you get older, your investments should shift toward the more conservative side.
No matter your age, it's still a good idea to allocate at least a portion of your portfolio toward stocks to help your investments grow faster. By investing strategically in index funds, though, you can limit your risk while maximizing your rewards.