Is it time to throw in the towel with your 401(k) plan? Over the last year, more than $1 trillion dollars has simply evaporated. Many investors diligently saved for years. Now they see that their account balances are down 40% or more. With no end in sight to this grim bear market, millions of Americans feel the overwhelming urge to unplug their 401(k)s.
Take the case of one of my good friends.
John is an excellent example of the perfect saver. A 40-year-old software engineer, he began contributing to his company’s 401(k) plan at the age of 22. He steadily increased his contributions over the years as his income grew. His investments are diversified. And he stuck to his plan through the good times and the bad (including the bursting of the dot-com bubble in 2000).
John called me in a panic.
His 401(k) has lost almost $180,000 in the last year. To make matters worse, his employer recently announced a round of layoffs. He went from being on track for early retirement to possibly not retiring at all. The abject fear in her voice sent shivers down my spine.
He fired off several questions in quick succession.
Should I keep making contributions? Should I move everything in cash? Should you take out a loan from the account to pay off your debts?
This is what I told him.
401(k) Tip #1: Make a plan.
Everyone should have a solid plan to achieve their retirement goals. If you don’t know how much money you need for retirement, there’s no way you’ll know how much to save or how to invest it. And, when times are tough, your plan will help you assess the damage to your portfolio.
401(k) Tip #2: Keep making regular contributions and increase them if you can.
The worst time to stop contributing to your 401(k) is when the market is down. Think about it. When the price of gasoline drops, do you stop filling up your car? No. If anything, it fills up more often before prices go up again.
The same principle applies to your 401(k). You want to keep growing your investments (and buy more if you can) while they are being sold at a discount. Lower prices mean you can buy more shares with the same contribution. This lowers your average cost base and sets you up for higher returns when the market picks up (and trust me, it will).
401(k) Tip #3: Review your asset allocation.
The foundation of your retirement plan is your asset allocation strategy. This is the optimal mix of stocks, bonds, and cash for your portfolio. The right mix for you depends on your specific goals, time horizon, and risk tolerance. Research shows that more than 90% of your long-term investment returns are determined by your asset allocation.
Right now is a critical time to review your asset allocation. While his gut tells him to sell the stock outright, his asset allocation might tell him to buy more. Following a solid asset allocation strategy will bring discipline to your decision-making and better long-term returns.
401(k) Tip #4: Diversify your investments and keep costs down.
As the old saying goes, “don’t put all your eggs in one basket.” Spread your investments across several different mutual funds. Diversify by company size through large-, mid-, and small-cap stock funds. Get exposure to both growth and value investing styles. And don’t forget to include an international background.
Keep your costs down by selecting funds with lower expense ratios. The country’s expense ratio for management fees and marketing costs. Don’t give away more of your money than you owe.
Index funds will have the lowest expenses because they are not actively managed. The expense ratios of small-cap and international funds are higher on average than those of domestic large-cap stock funds. As a general rule of thumb, you shouldn’t pay more than 1.5% for a stock fund.
401(k) Tip #5: Don’t transfer all your assets to cash just because the market is down.
I know it’s scary to see big losses in your account, but mistakenly selling when the market is down is catastrophic. Right now those losses are on paper. If you sell, you lock in those losses forever. If retirement is still years or decades away, you have plenty of time for your portfolio to recover.
401(k) Tip #6: Borrow from your 401(k) only as a last resort.
In these tough economic times, the temptation to borrow from your 401(k) can be overwhelming. My advice is to exhaust all other options first. And make sure the purpose of the money is important enough to justify dipping into your retirement plan.
Consider the consequences of taking the loan. Every dollar you take out of your plan is one less dollar providing tax-deferred growth. If you don’t repay the loan or make scheduled interest payments, the loan could be treated as taxable income. And, some plans require borrowers to suspend contributions to their plan for a period of time.
After I passed on my 401(k) tips, John felt much better about his situation. He will review his plan, assess the damage to his portfolio and make reasonable adjustments. He will also explore other options for paying off his debts before taking out a loan from your 401(k).
Right now is a critical time for your retirement plan.
Don’t let fear of the bear push you into making a catastrophic mistake. Follow my 401(k) tips and take back control of your future.
