How will a recession affect your 401(k)?
The Federal Reserve‘s aggressive campaign against the highest inflation in decades is looking bleak. Experts are now projecting a fed funds rate of 4.5% or higher by 2023, a level not seen since 2008. The Fed’s spate of 75-basis-point, or 0.75-percentage-point, interest rate hikes throughout the summer and September are expected to continue, with prospects for the economy shifting from a “soft landing” to a “hard landing.” Markets have repeatedly sold off, with both the S&P 500 and Nasdaq Composite indexes down more than 20% year to date and in bear market territory. Even investors with balanced portfolios have suffered as the benchmark 10-year Treasury yield spiked to above 4% in October, causing bond prices to fall in tandem with stocks. Despite these woes, investors should remember to stay the course, think rationally and plan for the long term. Here are eight rules to help you manage your workplace retirement plans during a recession.
Don’t chase recent performance.
Some asset classes have performed exceedingly well this year. Namely, commodities, short-term bonds, and alternative investments like managed futures have all posted positive returns. Some investors might be tempted to chase this recent performance and buy well-performing assets. The risk here is reversion to the mean. After such a large run-up, the chances of an investor buying these assets at their peak is much higher. This can cause investors to “buy high,” which depresses future expected returns. A good idea here is to refer back to your investment policy statement. If it doesn’t call for an allocation to these assets, consider exercising caution and refrain from impulse purchases.
Don’t try to time the market.
Facing a sell-off day after day and seeing your account value go down can be exceedingly difficult to bear. Given the average investor’s tendency toward loss aversion, some may try to sell their risky assets and move to cash, with the goal of “buying back in at the bottom.” The problem is that market bottoms are extremely difficult for investors to predict. Bear markets are capable of volatile up-and-down movements, including false bottoms and brief relief rallies called “bull traps.” A better solution is sticking to your chosen asset allocation and rebalancing it on a schedule. Keeping this as mechanical and systematic as possible will help minimize behavioral mistakes.
Don’t panic-sell your bonds.
Investors who held bond funds in 2022 have been shocked by steep declines due to rising interest rates and bond yields. Over the last few decades, bonds provided a cushion during bear markets and recessions as rates trended downward. They held a low-to-negative correlation with stocks, which made them useful as a diversifier. While this may not be the case in 2022, an allocation to bonds is still sensible. Bonds can still reduce portfolio volatility and provide income potential. With yields going up, their future expected returns are greater. Matching a bond fund’s duration to your time horizon is also an excellent way of mitigating interest rate risk.
Don’t panic-sell your stocks.
Every financial crisis has pundits screaming “this time it’s different,” or “sell now before it’s too late.” It’s easy for investors to get caught up in the hysteria that the stock market won’t recover, but taking a step back and looking at the big picture is a better idea. Take the performance of the overall U.S. stock market for example, which faced two back-to-back years of losses in 1973 and 1974, three straight years of losses from 2000 through 2002, and a brutal 37% drawdown in 2008. From 2000 to 2010, U.S. stocks experienced a “lost decade” with an annualized 1.2% return. Despite these bad periods, from 1972 to the present the U.S. stock market returned an annualized 10.13%. If your stock allocation is broadly diversified, stay the course and think long term.
Take advantage of employer matches on contributions.
When markets are tumbling, investors may be hesitant to contribute more money to their 401(k). It doesn’t feel good to contribute and then see it immediately drop 5% the next week. However, taking advantage of an employer match on contributions is one of the best ways of ensuring an instant return on your investment. There aren’t many free lunches in investing outside of diversification, and employer matches are one. For example, if your employer matches your contributions up to 4% of your salary of $100,000 per year, you’re getting $4,000 worth. When markets are down, this can help buoy your portfolio and boost asset purchases at lower valuations.
Revisit your risk tolerance and asset allocation.
Most investors think about risk tolerance as the average volatility they are prepared to endure. For example, an investor might be willing to see up to a 20% unrealized loss in their investment’s value. The problem with this approach is that it can be highly theoretical. It’s easy to think to yourself and say, “a 20% loss is fine.” It’s less appealing when your 401(k) has a value of $100,000 and a 20% loss means seeing it go down by $20,000. A recession or bear market is a good time to get honest with yourself and critically assess your true risk tolerance. This can mean revisiting your asset allocation for the future and allocating more to conservative assets like short-term bonds or money market instruments.
Don’t be swayed by fancy investments.
Alternative, hedge-fund-like investments have performed admirably year to date. Many of these investments purport to deliver positive expected returns under all market conditions, with a low correlation to stocks and bonds. They can use a variety of strategies, including long/short equities, systematic trend following and complex derivatives and volatility products. They’re also expensive, complicated and prone to years of underperformance. For most investors, a balance of stocks, bonds and cash will work just as well with lower fees and better simplicity. Investors should resist falling prey to the “shiny object effect” and stick to basic asset classes.
Keep fees low.
A perennial practice in bull and bear markets alike is to keep expense ratios low. During a recession, this practice can help keep more cash in your account. 401(k) fund choices can be overwhelming, with nondescript names and esoteric descriptions. A good way to start your search is by sorting your fund options in ascending order based on their expense ratios. Nowadays, expense ratios for some funds can trend as low as 0.03%, which works out to around $3 annually in fees for a $10,000 investment. Over time, the opportunity cost from high fees can eat into your expected returns. A dollar spent on fees is a dollar not put to work compounding. For most investors, sticking to simple, low-cost index funds is ideal.
8 rules for managing your 401(k) in a recession:
— Don’t chase recent performance.
— Don’t try to time the market.
— Don’t panic-sell your bonds.
— Don’t panic-sell your stocks.
— Take advantage of employer matches on contributions.
— Revisit your risk tolerance and asset allocation.
— Don’t be swayed by fancy investments.
— Keep fees low.
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8 Rules for Managing Your 401(k) in a Recession originally appeared on usnews.com
Update 10/24/22: This story was published at an earlier date and has been updated with new information.
