401(k) Plans and Market Volatility

There is never a bad time to invest in your retirement, and turbulent stock markets are no exception. As stressful as bear markets can feel, market volatility is an intrinsic part of investing. Without it, there would be no opportunity for meaningful investment returns.

Unfortunately, many investors fail to recognize choppy markets as both temporary setbacks and buying opportunities, and instead view them as catastrophic. Several behavioral economists have found that when investors lose money, the memory of the loss is what sticks, rather than any subsequent gain, because people are inherently loss-averse.

Market corrections and 401(k) plans

When a market correction occurs, it’s tempting to panic and sell, turning what could have been temporary losses on paper into permanent losses of capital. This can be damaging, especially when it comes to your retirement savings.

“The years ahead will occasionally deliver major market declines — even panics — that will affect virtually all stocks. During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy.” — Warren Buffett, 2017 letter to Berkshire Hathaway shareholders

When you defer your income into a 401(k), you are investing for the long term and should therefore make decisions focused on the years ahead, rather than emotional decisions in the short term. Ideally, you’ll keep the money in your 401(k) without touching it for decades — if you begin investing for retirement in your twenties or thirties, you could be in the market for over 50 years!

No matter what the market is doing, you should contribute to your 401(k) regularly. By doing so, you utilize the power of dollar-cost averaging — investing a fixed amount of money at regular intervals over a long period — which enables you to buy shares at different price points, smoothing out your returns over time.

Portfolio diversification

Having a 401(k) also means that you can benefit from portfolio diversification, which is an essential strategy to help reduce the impact of market volatility. Your portfolio should include multiple asset classes, allowing you to attain better risk-adjusted returns. In other words, when an asset class, like U.S. stocks, is down, other asset classes, like U.S. bonds or emerging market stocks, may be up, helping to offset your losses.

Since hitting bottom during the financial crisis in the spring of 2009, the U.S. stock market has been marching almost steadily upwards for the last eight years, the second longest bull market since 1928. However, history has shown us that the sailing won’t always be this smooth. In recent decades, the market has seen other challenging periods, like from 2000 to 2002, when the dot-com bubble burst after 9/11, and on Black Monday in 1987, when the market dropped over 20% in a single day.

In a March 2017 New York Times article, Robert Shiller, a Nobel prize-winning economist from Yale, highlights two indicators that today’s market may be ripe for a pullback: The cyclically adjusted price-earnings (CAPE) ratio is high by historical standards, suggesting the U.S. market is overvalued, and investor sentiment is currently low in valuation and crash confidence.

While there are hints of a possible upcoming market correction, we can never know exactly when the next one will occur. We can’t predict the future, but we can plan our response to it. Your actions both before and during a market downturn can determine your success in the long term. Don’t let personal fear become your enemy; instead, stay the course by maintaining perspective and continuing to save.

Disclaimer: This content is provided for educational purposes only and is not intended to be construed as personalized investment advice.