Even the most robust markets are prone to periodic downturns. Protecting a 401(k) against a sudden market decline is a concern shared by many investors. How do you safeguard your retirement account from fluctuations in the market?
The answer is clear: asset allocation and planning.
As Fidelity Investments has noted, the stock allocation for individuals approaching retirement age is often far too high. Maintaining the right balance between stocks and bonds is critical. For younger investors, 30 or 40 years away from retirement, an 80 percent/20 percent stock-to-bond ratio is perfectly acceptable, as they have a longer time horizon and can weather out stock market volatility.
However, this is not a prudent strategy for older individuals; in fact, in many cases, it can prove devastating. During the recession, portfolios with 80 percent of their 401(k) invested in stocks endured a 40 percent decline in value, compared to only a 20 percent loss for those with 40 percent in stocks and 60 percent in bonds. As retirement nears, a larger percentage of your 401(k) should be allocated to bonds, which can reduce volatility.
To calculate your ideal stock-to-bond ratio, financial planners recommend subtracting your age from 110. So this would mean a 30-year-old would have 80 percent in equities and 20 percent in bonds. Conversely, a 60-year-old entering into retirement would have allocated her 401(k) balance evenly between stocks and bonds. This formula can always be modified, as some investors have a greater capacity for risk than others.
All investors, no matter their age or financial wealth, should review the asset allocation of their 401(k) balance at least once a year. Market performance can skew the stock-to-bond ratio. A bull market will increase the percentage of a portfolio’s value in stocks, in which case an investor should consider taking advantage of auto rebalancing. This service automatically resets your asset allocation to a predetermined ratio, helping you stay on track to reach your long-term financial goals. This particularly makes sense for your 401(k), where there will be no current year tax consequences as a result of any gains realized as part of the rebalancing.
If your stock to bond ratio goes from 60:40 to 57:43, that is not necessarily the signal to rebalance. Once a year is generally sufficient. Having sufficient cash reserves outside of the 401(k) plan also takes the pressure off of constantly adjusting the 401(k). Balance is particularly important as it relates to managing your asset allocation. I always advise clients that you certainly don’t want to “set it and forget it,” nor do you want to “day trade”.
Some account holders may not even be aware of their stock-to-bond ratio, and not everyone has the time and inclination to become a financial expert. That’s why it is so important to establish a financial plan and work with a CFP® professional.