It's been a tough few weeks in the banking sector, and that turmoil is probably affecting your retirement accounts. High-profile bank failures and concerns about a full-on crisis are moving stocks and bonds. Consider these three steps to protect your retirement account from any retirement forces that could be causing problems.

1. Prepare for stock market volatility

In the short term, a banking crisis is almost certain to cause volatility and drive stocks lower. Turmoil in the banking sector leads to tighter lending standards, which stunts corporate growth and consumer spending. This increases the likelihood of a recession, especially with interest rates at elevated levels. Economic uncertainty and slowing corporate growth generally send stocks lower.

A long line of people at an ATM trying to withdraw money.

Image source: Getty Images.

Banking stocks are another consideration themselves. Bank stocks have dropped sharply over the past month, with smaller regional banks taking an even larger beating. Several high-profile bank failures and concerns about other distressed institutions put investors on edge. This dragged the whole sector down, due to higher perceived risk of contagion that would negatively affect the operating performance of many banks.

Chart showing the prices of SPDR S&P Bank ETF and SPDR S&P Regional Banking ETF falling in 2023.

KBE data by YCharts

Volatility is an unavoidable aspect of stock market investing, and investors simply have to accept that. Since there's no good way to eliminate volatility from your equity portfolio, the best move is to focus on managing it. Here are the two best ways to do this:

  1. Ensure that your portfolio allocation matches your risk tolerance and time horizon.
  2. Prepare yourself emotionally for inevitable downturns, and commit to a reasonable strategy that you won't abandon during tough times.

Portfolio allocation is a well-studied field, and there are time-tested guidelines that will deliver the best outcome for almost anyone. In general, you want to prioritize growth in your retirement account when you're younger by allocating heavily to equities, with growth stocks more heavily represented in your portfolio. As you get older, volatility becomes a more important consideration than growth. You should introduce bonds into your retirement portfolio to lock in decades of gains and limit volatility.

Beyond the age consideration, people who have low personal risk tolerance should also consider portfolios with higher bond concentration, and more exposure to dividend stocks and value stocks within their equity holdings.

2. Diversify equity holdings

Active investors might hold a few high-conviction stocks in a brokerage account, but it's usually good practice to have a diversified investment portfolio in your retirement account. Most 401(k) plans won't even let you buy individual stocks, pushing investors into exchange-traded funds (ETFs) and mutual funds instead.

The latest turmoil in the banking industry is a clear illustration of the importance of diversification. The recent bank failures wiped out enormous amounts of shareholder value -- SVB Financial Group shares were trading at nearly $300 at the start of March. That's devastating for anyone who happened to be heavily exposed to that stock, and that's exactly why high portfolio concentration in a retirement account is reckless for most people. If you held 30 different stocks in an IRA or had indirect exposure to hundreds of stocks in a 401(k), SVB's failure probably barely registered.

It's not enough to simply hold a large number of stocks, either. It's important to consider correlation and sector exposure. Contagion fears and common trading patterns meant that almost every bank stock sank when a few industry constituents endured a crisis. Your retirement account shouldn't be too heavily exposed to any individual industry or sector.

Most investors don't have heavy concentration in bank stocks, but you might want to consider the allocation of certain ETFs and mutual funds in your account. Older investors who increased exposure to value stocks likely changed the balance of sectors in their portfolios, and many value ETFs were overweight toward the financial sector coming into the year.

3. Diversify bond holdings

Bond markets were also affected by the banking sector, which has major implications for retirees. In the past, the Fed has slashed interest rates in response to financial crises. This provides liquidity to banks, and it helps institutions avoid SVB's fate of selling securities at losses to cover cash needs. As high-profile bank failures hit the headlines, bond investors signaled their belief that rate cuts are imminent. Bond prices reversed course from February to climb in March, while the interest rates on newly issued securities fell.

Charts showing fall in the S&P 500 Bond Index and 10-year Treasury rate in 2023.

^SPXBA data by YCharts

This all happened despite the Fed's announcement that it was still increasing interest rates. These conditions create an odd situation for retirees. If rates get cut, it will send existing bond prices higher. Most retirees have significant bond exposure in their retirement accounts, so that's good news for asset values. However, falling interest would push yields down on any securities that they purchase later this year.

The best course of action here is diversification. If you hold bonds with various maturity dates, then interest rate fluctuations shouldn't have as much of an effect. This strategy is commonly called laddering, and it's probably done automatically for your retirement account if you hold bond ETFs or mutual funds. It's also important to diversify bond issuers in your holdings. This keeps one government, company, or sector from interfering with portfolio performance.