Now is not the time to cut back on contributing to your 401k
As the U.S. stock market cratered in March, did you panic and stop contributing to your 401k?
If you didn’t change your contribution, you’ve passed the first test of an economic crisis as an investor: don’t stop buying stock simply because your investments are down. In fact, it’s better to buy stock while the market is down, since you’re generally getting more shares for your money.
Financial advisers recommend a continued and constant contribution to your 401k because by doing so, you take advantage of the market’s ups and downs, without letting emotion get in the way. Human instinct has trained us to run from danger, but when it comes to the stock market, this fight or flight response actually works against us.
By contributing the same amount over time, investors can take advantage of dollar cost averaging. Dollar cost averaging involves investing a fixed amount of money at regular intervals over a long period of time.
The number of shares you purchase each month will vary depending on the price of the mutual fund or exchange traded fund at the time. When share prices drop, your money will buy you more shares.
Here’s a chart Fidelity Investments created to show the impact of missing out on the stock market’s biggest days of gains, which often follow in the wake of huge stock market declines. The chart shows what would happen to an investment of $10,000 in a S&P 500 index fund from 1980 to 2018 if you missed the best five, ten, 30 and 50 market days. (The chart ignores taxes and fees for simplicity; taxes from frequent selling could eat into your returns even more.)
As you can see, trying to time the ups and downs of the market can put your portfolio in peril.
This isn’t to say you shouldn’t rebalance your portfolio over time. Rebalancing typically involves shifting between more aggressive and more conservative assets.
Those who had most of their investments in U.S. domestic stocks likely saw the value of their investments swell through the end of 2019 as the U.S. enjoyed the longest bull market in history. But they saw huge declines in March as the market pulled back to where it was in 2017. Though the market has retracted much of its recent losses, huge market events can demonstrate the value of having a balanced portfolio, which is particularly important as we age.
What does balance look like?
In the past, the investment community suggested taking your age and subtracting it from 100, to determine what percentage of your portfolio should be held in stocks and what percent held in bonds. In other words, at age 20 they would have suggested you have 80% of your portfolio in stocks and 20% in bonds, and at age 30, 70% in stocks and 30% in bonds.
As life expectancy has increased, this thesis has been challenged (you can read more here). Bonds typically fluctuate less in value and produce smaller returns than stocks, so they’re good at preserving capital as we age. The downside is, with smaller returns, we might outlive the value of our investments. Mutual fund companies have responded by creating target-date funds, which automatically shift into more conservative investments as you approach retirement.
To manage your portfolio in a crisis, it’s best to be prepared in advance, which means sticking to the types of investments that will produce a good return over the long run and provide a margin of safety you can live with. Now that the market has retraced much of its losses — as of this writing, the S&P 500 is down 13 percent from its 2019 high — it might be time to revisit whether you have the appropriate balance of stocks and bonds for your age group.
Oftentimes, as our stock portfolio grows, it becomes a larger and larger share of our portfolio, crowding out less volatile investments. If you retired in March, you’d have wanted to have had a good share of cash and bonds to draw on, so you wouldn’t have to sell your stocks in a down market. (Most bonds also declined, but generally to a lesser extent.) Investment advisers also typically recommend you keep cash on hand equivalent to six months of expenses, though obviously this amount can change depending on your personal circumstances.
You can read more about investment portfolio rebalancing at Morningstar, an excellent investment website we highly recommend.
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