How Do 401(k)s Deal with Market Downturns?
September 16, 2020
By Rahul Iyer
In 2018, financial services firm Fidelity reported that the average 401(k) balance fell 10% during the fourth quarter that year. At the time, fears of a recession were looming and this caused many people to worry about the future of their 401(k) plan. Now in 2020, we're facing similar fears due to the widespread economic disruption caused by COVID-19. So how do 401(k)s deal with volatile markets and market downturns? And how you should act? Let's take a look.
The Impact of Market Downturns on 401(k) Plans
It should come as no surprise that the last 20 years weathered a fair share of market instability. In fact, up to the end of 2019, six out of ten of the best days in the market occurred within two weeks of the ten worst days! But how do these ups and downs impact 401(k) plans? Like any investment, 401(k)s are financially impacted by market downturns, but evidence seems to show that they weather these storms better than other plans.
For example, during the 2008/2009 recession, the S&P 500 fell by 37% between 2007 and 2009. However, 401(k) balances only fell by 26% in the same period. When the dot-com bubble burst in 2000, the S&P fell by 31% from 1999 to 2002, yet 401(k) balances dipped only 8%, before recovering entirely .
The reason that 401(k)s weather market downturns better than most is largely due to their diverse nature. 401(k) plans are typically not just stock investments, but instead have a balanced investment profile consisting of real estate, stocks, bonds, and other investment classes. This allows 401(k)s to be more resilient by reducing the overall investment risk.
How Should You Treat Your 401(k) During a Market Downturn?
Try to keep emotions out of it - When we see stocks falling, our levels of anxiety increase. This is natural, but try to not make big decisions when you're emotional. Countless 401(k) plans have bounced back from recessions in the past. This means if you are on the younger side, you have a long time for those losses to turn back to profits.
Try to avoid making early withdrawals - If you withdraw your money early, you will face a 10% penalty and owe any deferred tax. Tapping into your 401(k) should be a last resort.
Keep contributing - If you have a salary still coming in, then experts recommend that you should keep contributing to your 401(k). Ideally, you should always be contributing to your 401(k) and your emergency savings fund.
Be mindful of matching - If you're thinking of reducing your contributions, have a read of your employer's matched contribution guidelines. If you reduce your contribution, you could be losing out on free money put in by your employer. Ideally, you should always be contributing at a level where you make full use of the matched benefits.
Evaluate your risk tolerance - If you want to take greater control over your financial profile, then consider evaluating your risk tolerance. This is essentially about assessing how much volatility you can handle. For example, would you be willing to risk losing $30,000 to make $40,000? If so, then you have a higher than average risk tolerance. However, if you can't afford to lose $5000, then you likely need to be conservative with your investments. Market downturns are a good time to analyze your portfolio and consider what type of investments you should make in the future.