How to protect your 401(k) from a market crash

You’ve spent much of working life building up your 401(k) and then along comes a severe market downturn to threaten your retirement plans. What can you do to ensure that your portfolio stays protected?

The first step is to avoid panicking. Market corrections and cyclical downturns can happen every few years, and they are likely to occur several times throughout the life of your 401(k). While it can be uneasy, market crashes are an important time to stay in longer-term investment accounts and not make emotional short-term decisions that could cost you dearly later.

Market crashes can be unpredictable but prepare for them as best as you can. In the past, many investors stuck to a “60/40” method of investing by placing 60% of their portfolio into equities and 40% into bonds. That advice has changed along with evolving market forces, and experts now offer up new ways of mitigating market risk.

Here are some ways to protect your hard-earned 401(k) when the market heads south.

Experts seem to resoundingly agree that staying the course in your 401(k) is important, even during uncertain times.

“You want to keep investing consistently with your goal in mind from the start,” says Anessa Custovic, chief information officer and investment adviser representative at Chapel Hill-based advisory firm Cardinal Retirement Planning. “Don’t let a recession deter you from adding money into your 401(k). Don’t let yourself make an emotional decision due to a recession or bear market.”

Taking money out of the market during times of volatility can have the opposite effect of your long-term goal.

“We believe the key thing to do is to keep your 401(k) funds invested,” says Eric Phillips, a financial analyst and senior director at San Francisco-based 401(k) provider Human Interest. “If you take them out of the market, you may lock in losses and could miss out on opportunities for market rebounds.”

One good way to align your retirement planning goals with your investments is dollar-cost averaging. This method involves investing a fixed amount of money (or a set percentage of your pay) into your 401(k) each month, regardless of outside market conditions. For most people participating in a 401(k), this already happens automatically based on how they make their contributions.

This can eventually make your break-even point lower, which can help you to recover losses faster once the market rebounds.

It’s also important to remember that employer matching contributions increase your returns, regardless of market conditions. Matching can provide an instant return, often 25% to 50% or more, even if the market is in a downturn.

Once you’ve steadied your nerves in the face of a down market, it’s crucial to consider when you’re looking to retire. This step is important, because a 57-year-old nearing retirement will have to approach market downturns with a different strategy from a 32-year-old.

Investors who are close to retirement, meaning about five to seven years away, could do well to have a financial plan for their 401(k) beforehand, and then refer to it in times of market trouble. A plan is usually drafted with a financial adviser or a representative from your 401(k) provider.

“This doesn’t have to be a 50-page document with fancy charts and graphs,” says Eric Presogna, an accountant and CEO of Pennsylvania-based advisory firm One Up Financial. “It could be something as simple as a one-page summary of all your investments, income, and net worth with a sentence or two memorializing your investment strategy and philosophy.”

These kinds of professional financial plans often take market crashes and bear markets into account, along with many other market scenarios, so when a crash strikes and you’re nearing retirement, you can refer to them and be reassured you’re doing what’s best for you.

Dean Elliott, a fiduciary adviser and managing partner at Global Wealth Advisors, a Texas-based advisory firm, suggests a 401(k) stress test for investors nearing retirement: “This will enable them to see what might happen during different market scenarios such as interest rate increases, bear markets, bull markets or even a financial crash, and then adjust their investment portfolio accordingly.”

Stress tests are a good idea for investors of all ages, but particularly useful the closer you are to retirement.

For investors who are 59½ years of age or older, a good option might be to roll over your account to an IRA, which will allow for more investment options.

“This opens up virtually unlimited options for your investments, and you can find other ways to diversify and protect yourself in down markets,” says Anthony Pellegrino, founder and principal at Illinois advisory firm Goldstone Financial Group.

For investors with a longer time horizon until they need to begin drawing on their 401(k) assets, the strategy is a little simpler.

“Younger investors are not going to touch their 401(k) for decades, so the fluctuations right now are simply noise. I understand that noise can get pretty loud and annoying, but that doesn’t mean you need to make wholesale changes,” says Brian Walsh, a financial planner and senior manager of financial planning at SoFi.

The best way to prepare your 401(k) for downturns is to make sure you have a solid investment plan in place before a crash happens. Make sure you build a well-balanced and diversified portfolio to begin with, or assess and diversify now if you have not already done so.

It’s important to rebalance your portfolio regularly to make sure it is aligned with your time horizon and risk tolerance. Rebalancing your portfolio on a regular basis will help to ensure that your allocation will not go too far out of alignment when one asset class goes higher in value than others.

“Rebalancing enables investors to take advantage of buying low and selling high to assure their allocation is where they would like it to be,” says Elliott.

He recommends a yearly rebalancing, if not every six months, to make sure your portfolio is allocated appropriately.

Diversifying your portfolio across different asset classes and markets also helps to reduce exposure to one particular segment of the market during market downturns.

In the past, most advisers would suggest an allocation of 60% equities and 40% bonds to balance out an investment portfolio. Times have changed, especially in the post-pandemic economy, and the old benchmark might need rethinking, say some experts.

“The current market is different from previous periods of volatility because it is affecting stocks and bonds,” Walsh says. “In the past, bonds could serve as a ‘safe haven’ during periods of stock market volatility, but not this time. Bonds are holding up better than stocks, but a 60/40 portfolio is on track for one of its worst years ever. When combined with multi-decade high inflation, this is especially troubling for those in or near retirement.”

This year has seen a historic rise in interest rates to combat high inflation.

“As a result, high-quality fixed income isn’t providing investors with the downside protection they’re used to, as bonds are down nearly as much as stocks in 2022,” Presogna says.

With bonds not being the mainstay they once were, investors will need to get creative to invest defensively if they suspect a further crash is on the way.

Again, for investors with long time horizons, experts seem to agree that it’s likely best to stay put and ride the wave out while making sure you’re always diversified.