Market down swings and up swings can happen quickly and without warning. Yes, it’s pretty much impossible to time the markets, and when there is a big market down movement, it can be stressful. What should you do?
First know this: you haven’t lost any money even though your 401(k) value has dropped. You only recognize a gain or loss when you take a distribution. Most folks won’t tap their 401(k) balances for 10, 20, 30 or even 40 years. Second, since 1926, there have been 14 recessions and 14 market recoveries.* We like that batting average for recoveries. And third, in every 20-year period researched back to 1926, the US stock market has delivered positive returns.**
While history offers no guarantees, here are some additional perspectives that can help you more confidently determine the right path for you through good times and bad.
Jumping In and Out of the Market Is Typically a Bad Idea
Given that markets can swing quickly, it can lead to some bad outcomes if you jump in and out of the market (if experts could time the market, they’d be retiring very young – we’re not seeing that). Some investors get so nervous during a big stock market drop that they move their 401(k) money out of stock funds into a money market or similar cash equivalent, essentially selling stock at a low. Then when markets rise, they feel more confident and move the money back to stock funds thereby buying at a higher point than they sold and missing the opportunity for a better return.
Looking at the 20-year S&P 500 returns (index of the top 500 businesses in America) from 1999-2018, the S&P delivered an annual return of 5.62%. Not bad especially when you consider this includes the horribly negative returns of the Great Recession of 2008-2009 (and that since 1926 the S&P has averaged over 10% returns per year). If you had moved your money out of the S&P 500 during this 20-year period and missed the 30 best days, you would have experienced -0.33% return per year (yes that is negative each year). This is a very big deal.
To make this point crystal clear, consider this hypothetical example. Let’s say two 401(k) investors, Anne and Alex, each had balances of $25,000 in their own accounts at the end of 1998. Each contributed $3,600 per year for 20 years, and each initially was investing in a S&P 500 like fund. Anne stays with her S&P 500 investment and earns 5.62% each year over the next 20 years. Alex gets nervous during market down swings and moves his money in and out of the S&P 500 and ended up with average return of -0.33%. The difference in their nest egg values is remarkable.
Stay the Course vs. Not
Anne has more than double the nest egg value of Alex with $205,338 vs. Alex’s account value of $93,072. That’s the big deal.
Down Markets Can Actually Be a Powerful Buying Opportunity
So you can see jumping out of the market in bad times and back in during good times can be costly to your nest egg. The beauty of automatic investing with each payroll in an 401(k) account is that you buy more of a fund in down markets due to the lower prices and less of a fund in good times. This is called dollar cost averaging, and it can help you achieve greater returns over time (of course, there are no guarantees). This example shows how it can work.
The Upside of Dollar Cost Averaging
|Period||Amount Contributed||Fund Share Price||Shares Purchased|
|1 (market high)||$500||$100||5|
|2 (market low)||$500||$50||10|
|3 (recovering market)||$500||$75||6.67|
|Value||$1,625.25||21.57 shares x $75|
By sticking with your investing plan in this scenario, your account value is currently 8.35% better off even though the market has not come close to exceeding the previous high of $100 per share. Pretty cool.
Choose Your Strategy for How Much You Put in Stocks and Bonds
Here’s the thing. We aren’t all comfortable with big swings in the markets and typically the closer we are to using the money, the less we want to experience these swings. Historically, large cap stock funds have returned 10% per year since 1926, government intermediate bonds over 5% and cash over 3% (note that most savings accounts and money markets are offering interest rates of less than 1.5% currently).
Stocks have also been much more volatile versus bonds and cash. Generally, the more you invest in bonds and cash, the less volatile your portfolio is. The more in stock, the more volatile it is. The old rule of thumb is to put about your age as percentage in bond funds and the rest in stock funds for your 401(k). So, if you are 30, you’d put 30% in bonds and 70% in stocks. This can be fine when you are less than 50 years of age, but you may want to have less in bonds than your age after reaching this age.
If you’re 60 years of age or more and thinking about retirement, having some broadly diversified stock funds in your portfolio is a good thing. Most people expect to live 20 to 30 more years past 60 giving you time to ride out a downturn. Keep in mind, it’s important for you to have revenue generating assets like bonds and cash to cover at least 5 years when you retire to help your stock holdings persevere a down market. When the market recovers you can adjust your overall allocations between stocks, bonds and cash holdings and likely be better off. Most importantly, pick an allocation that helps you rest better at night. We hope you find this helpful perspective. Be well and prosper.
* US Business Cycle Expansions and Contractions available at http://www.nber.org/cycles.html
** 2019 SBBI Yearbook, U.S. Capital Markets Performance by Asset Class 1926-2018. Duff & Phelps, LLC. Data use Morningstar, Inc.