Even after a long stretch of smooth sailing, a stint of choppy waters can leave you on edge about what happens next. That's how many 401(k) savers are feeling after the coronavirus-fueled market crash last March. According to a recent survey from investment manager and insurance provider Principal, 29% of workers are very concerned about future stock market volatility and how it will affect their wealth.
That concern is understandable. It's both frustrating and scary to realize your retirement depends on the stock market, but you can't predict or control its behavior. The thing is, a rough patch in the market doesn't automatically mean the end of your 401(k) or your chances for a comfortable retirement. Here are three reasons why.
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1. You are appropriately invested for your age
Your age determines how many years you have until retirement, which is also your 401(k) investment timeline. That timeline should strongly influence your investment approach.
When retirement is still decades away, you can invest more aggressively in equities to maximize your earnings growth. As you near retirement, it's smart to balance those equity positions with a greater percentage of bond holdings. Bonds don't grow the way equities do, but they have a stabilizing effect on your portfolio.
More specifically, your percentage of equity holdings should be something close to 110 minus your age. Using that guideline, your portfolio at age 30 would consist of 80% equity funds and 20% bond funds. At that level of equity exposure, a big market downturn will reduce the value of your 401(k). But since you don't need the money for 30 or 35 years, you can simply wait for the market, and your balance, to recover.
That dynamic changes as you near retirement. At age 60, you don't have all the time in the world. You may be only a few years from taking retirement distributions, and that's the wrong time to see your 401(k) balance tank by 20% or 30%. You'd insulate yourself from that outcome with a lower equity percentage, say 60% equities and 40% bonds. That way, a market downturn won't cut as deeply into your balance.
2. You will keep making contributions through a downturn
Market volatility takes its toll on the value of your portfolio, but it also creates opportunity. If you continue on with your normal 401(k) contributions even as share prices are dropping, you'll be picking up more shares for the same total dollar amount. That lowers your overall cost basis. And more importantly, it positions you to benefit nicely when those share prices rebound.
3. You have an emergency fund
If you don't have an emergency fund, you probably have two ways to raise cash fast when something bad happens. You can charge the emergency expense to a credit card, or you can pull the money from your 401(k).
Either option is destructive financially, but draining your retirement account has long-lasting consequences that are difficult to overcome. That's particularly true if you had to withdraw the funds while share prices are down. At that point, you've realized losses, and you no longer have the opportunity to participate in recovery gains on the shares you liquidated.
Maintaining a cash emergency fund protects you from having to tap into your 401(k) or add big charges to your credit card. Shoot for a balance that will cover three to six months of your living expenses. And if you have to use the money for something, plan on replenishing it as fast as you can.
Stay the course
The market may get choppy in 2021, or it may not. There's truly no way of knowing. But if the worst happens, know that your 401(k) will survive -- as long as you are invested according to your retirement timeline, you stay the course with your contributions, and you keep extra cash on hand to help you through those rough waters.
