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How to Protect Your 401(k) From a Stock Market Crash

·6 min read
There are several steps you can take to protect your 401(k) from a stock market crash.
There are several steps you can take to protect your 401(k) from a stock market crash.

Market volatility is inevitable. Corrections happen every one to two years when stocks decline 10% or more from their most recent peak and usually last several months. Stock market crashes, on the other hand, are less common than corrections but more abrupt and severe. Look no further than the 2008 financial crisis or the 2020 crash ushered in by the coronavirus pandemic. But preparing for market volatility is possible. A financial advisor can help you shore up your retirement savings for inevitable market events. Here are five ways to protect your 401(k) nest egg from a stock market crash.

Diversification and Asset Allocation

Allocating the right amount of money to a diverse array of assets is crucial to protecting your 401(k) from a stock market crash, while also maximizing returns. As an investor, you understand that stocks are inherently risky, and as a result, offer higher rewards than other assets. Bonds, on the other hand, are safer investments but usually produce lesser returns.

Having a diversified 401(k) of mutual funds that invest in stocks, bonds and even cash can help protect your retirement savings in the event of an economic downturn. How much you choose to allocate to different investments depends in part on how close you are to retirement. The further you are from retiring, the more time you have to recover from market downturns and full-fledged crashes.

Therefore, workers in their 20s would likely want a portfolio more heavily weighted in stocks. While other coworkers nearing retirement age would probably have a more even distribution between lower-risk stocks and bonds to limit exposure to a market drop.

But how much of your portfolio should be invested in stocks vs. bonds? A general rule of thumb is to subtract your age from 110. The result is the percentage of your retirement portfolio that should be invested in stocks. Investors who are more risk-tolerant will subtract their age from 120, while those who are more risk-averse will do the same from 100.

Rebalance Your Portfolio

There are several steps you can take to protect your 401(k) from a stock market crash.
There are several steps you can take to protect your 401(k) from a stock market crash.

Rebalancing your portfolio, or changing how much you have invested in different assets, is another vital component of protecting retirement savings from crashes. The idea is that over time, some investments may fare better than others, changing the percentage of money invested in each asset and potentially exposing you to elevated risk. By rebalancing, you bring the percentage of money invested in stocks and bonds back in line with your original investing target from the section above.

The easiest way to ensure your 401(k) is continually rebalanced is to invest in a target-date fund, a collection of investments designed to mature at a certain time. Target-date funds automatically rebalance their investments, moving to safer assets as the target date approaches.

But if you pick your own investments within your 401(k), you’ll want to rebalance your portfolio manually at least once a year. Some financial advisors may recommend rebalancing as often as once a quarter. You can do this by selling off positions with gains that have tipped your portfolio out of balance. This is especially important for investors who are nearing retirement. It’s also worth noting that rebalancing isn’t the same as withdrawing money. These transactions are happening within your 401(k) and won’t immediately result in taxes.

Have Cash on Hand

Some financial professionals recommend retirees have enough cash or cash equivalents to cover three to five years worth of living expenses. Having cash reserves can help pay for unexpected expenditures that a fixed income may not otherwise be able to cover.

Cash on hand can also mitigate what’s called “sequence of returns risk.” That’s the potential danger of withdrawing money early in retirement during market downturns and, thus, permanently diminishing the longevity of a retirement portfolio. By selling low, which is what happens when a retiree withdraws money during a market slump, the longevity of the investor’s portfolio is jeopardized. However, with cash reserves retirees can withdraw less money from their 401(k) during a market decline and use the cash to cover living expenses.

Keep Contributing to Your 401(k)

Steadily contributing to your 401(k) is another way to protect it from future market volatility. Cutting back on your contributions during a downturn may cost you the opportunity to invest in assets at discount prices. Meanwhile, maintaining your 401(k) contributions during a period of growth when your investments have exceeded expectations is equally important. The temptation to scale back your contributions may creep in, but staying the course can bolster your retirement savings and help you weather future volatility.

Don’t Panic and Withdraw Your Money Early

There are several steps you can take to protect your 401(k) from a stock market crash.
There are several steps you can take to protect your 401(k) from a stock market crash.

Surrendering to the fear and panic that a market crash may elicit can cost you more than the market decline itself. Withdrawing money from a 401(k) before age 59½ can result in a 10% penalty on top of normal income taxes. It’s especially important for younger workers to ride out the market lows and reap the rewards of the future recovery.

Even people nearing retirement age may rebound from the crash in time for their first withdrawal. Consider the coronavirus-fueled crash of 2020 as a case study. The Dow Jones Industrial Average, which notched an all-time high of 29,551.42 on Feb. 12, 2020, fell to just above 19,000 by March 15, 2020. Then on April 15, 2021, it posted an intraday high of more than 34,000. Spooked investors who pulled their money from the market in March 2020 missed out on the bull market that pushed the DJIA to record highs by November 2020 – just eight months later.

Bottom Line

Protecting your retirement savings from a stock market crash requires you to pay special attention to your asset allocation and investment variety, rebalancing when needed. Continuing to contribute to your 401(k) through both bull and bear markets can bolster your retirement savings for the future, while remaining calm during times of volatility will keep you positioned to capitalize on the eventual recovery.

Tips for Protecting Your 401(k)

  • Consider talking to a financial advisor about investment strategies and protecting your 401(k). SmartAsset’s financial advisor matching tool makes it easy to connect quickly with professional advisors in your local area. If you’re ready, get started now.

  • A target-date fund will automatically rebalance over time, ensuring you remain primarily invested in stocks early in your career and shift to safer, more conservative investments as retirement nears.

Photo credit: ©iStock.com/D-Keine, ©iStock.com/martin-dm, ©iStock.com/Pears2295

The post How to Protect Your 401(k) From a Stock Market Crash appeared first on SmartAsset Blog.