How to Protect Your 401(k) From a Market Crash or Recession

You’ve saved all your life to build up your 401(k) plan, and now in this period of stock market turbulence, you’re worried about substantial losses. What can you do? Here are some suggestions for how to protect your 401(k) from a market crash or recession.

Of course, you can’t control what happens in the stock market, so focus on what you can control: yourself. Follow these simple tips to minimize your losses and maximize the chances that you’ll stay on track for a secure retirement.

Tip #1: Diversify (Duh!)

Yes, you’ve heard it before, but it bears repeating: One way to protect your portfolio is to stick with the tried-and-true strategy of diversification.

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It’s very unlikely that if you’re spread out over a number of different investment asset classes that they’ll all fall the same amount, and you might even see some go up.

The idea in being diversified is to increase the odds that your overall return will do better in a market drop than if you overweighted in a small handful of investments that happened to fall hard.

And while you’re at it, in light of the current higher inflation, if your company plan offers funds that provide an inflation hedge like REITS or TIPS funds, you may want to consider including these as part of your portfolio.

Be sure to rebalance your portfolio once a year to bring the percentage of money invested in the different funds back in line with your original asset allocation. This will prevent overweighting in areas of the market that may do well for a while but then end up dropping, which could subject you to bigger losses.

Tip #2: Keep Contributing Despite Downturns

Another important thing you can do to mitigate market losses in a market crash or recession is to continue contributing on a monthly basis into your 401(k) plan even as the market is going down.

This allows you to buy stocks at a cheaper price to compensate for some of the stocks that you may have bought at a higher price.

This is a form of dollar-cost averaging, which most of the time will help you get an average price on your shares that will be lower, compared to someone who gets rattled and discontinues buying shares every time the market goes down.

Tip #3: Know Your Risk Factor

One of the best remedies to make sure you don’t panic and pull your money out of the market after a big drop is to assess your risk tolerance, preferably before you start investing in your 401(k) plan. There are a number of risk-assessment tools, such as Riskalyze, that can help you do this.

For example, if the risk assessment shows you cannot tolerate more than a 10% drop in your portfolio, you can invest more heavily in bonds and cash equivalents and less in stock.

If it still turns out your portfolio has fallen more than you can stomach, the best thing to do before you bail out is to pause and think about it. Perhaps even talk to a friend with more experience investing in stock.

You also might consider simply reducing your stock levels to a more tolerable percentage of your portfolio rather than pulling out completely.

You may not recover as fast when the market goes up, but if the market continues dropping for a while, your downside risk will be more limited.

Remember: If you do pull out completely near the bottom, you may miss the recovery if history repeats itself and the market rebounds, which so far it always has.

Tip #4: Don’t Bet So Much on Your Employer

To reduce the chances of getting in the unfortunate situation where your company stock has a severe drop or actually becomes worthless, do your homework and learn some things about your company’s financial condition before you buy company stock in your 401(k).

Even if you conclude that the company you work for is in good financial shape, it’s still a good practice to not put more than 5% or 10% of your 401(k) funds into your company stock.

Just ask the employees of Enron who did this and saw their company stock become worthless.

Nothing in life is ever 100% certain, and that certainly includes investing in a 401(k) plan, but if you follow these time-tested principles of investing, the odds are you will be prepared for a comfortable retirement.