Top 7 Ways to Protect Your 401(k) from a Stock Market Crash
If you have a 401(k), any other retirement plan, or anything that ties into the stock market in general, then this article is for you. I’m going to tell you seven ways to protect your 401(k) from a stock market crash so that if it does happen, at least you will be prepared.
What is a 401(k)?
The 401(k) is an employer-sponsored, tax-deferred investment plan specially designed for retirement. It’s a particular type of investment account that an employer opens on behalf of their employees to deposit a portion of each employee’s salary and sometimes another voluntary contribution to match that of the employee.
There are two types of 401(k)s, the traditional 401(k) and the Roth 401(k). In the first case, contributions are made pre-income tax, and your taxes will be deferred until you withdraw your money during retirement. The Roth 401(k), on the other hand, allows you to make post-tax contributions, so you won’t have to pay any more taxes in the future.
How does the stock market work, and how can it affect your 401(k)?
The stock market is a public resource that everyone can use to invest in companies. When you buy a company’s shares, you’re purchasing a certain percentage of their business. So if they do well, your money will grow along with them, but if they do poorly, then you’ll lose part of your investment.
In layman’s terms, the stock market is the result of many buyers and sellers worldwide who trade stocks daily. These stocks can be from big, multinational, publicly-traded corporations like Apple, Tesla, and Meta (formerly Facebook), and smaller companies and startups from many different sectors of the economy.
What can happen to your 401(k) in case of a market crash?
When the stock market crashes, it means that there has been a sudden decline in stock prices for particular companies or investments. This can happen for many different reasons, including changes in interest rates, political instability, terrorism, and the onslaught of a pandemic, among other reasons.
But what does this have to do with your 401(k)?
When you contribute to your 401(k), your money is invested to grow over time. You can select from a list of investment options, and, in most cases, those options include stocks, among other assets. The value of those stocks, and therefore, of your investment, is dependent on the stock market’s performance.
If there’s a crash in the market, then odds are the value of your retirement fund will decline as well, making you lose a part of the money that will provide your livelihood once you retire. Therefore, it’s perfectly understandable that many who are about to retire constantly worry about protecting their 401(k) against a market downturn.
In the following section, you’ll find a list of the top 7 ways to protect your savings against market crashes.
How to protect your 401(k) from a stock market crash?
Many people are vulnerable to losses and don’t know how to protect themselves. If you want to protect your 401(K) from a market crash, here are some things you can do:
#1 Get involved and learn the ropes of the stock market.
Your 401(k) is basically an investment account, and to protect it from a market crash; you’ll need to start by learning everything you can about investing and the stock market. Unfortunately, many people avoid learning how the market works because they’re scared of losing their money if they invest incorrectly. However, you shouldn’t let this be your case.
If you want to retire with peace of mind and not have to worry about a new virus wiping out all of your savings without notice, learning the ropes is your first step. There are hundreds of books and resources you can choose from to learn the basics.
Once you have that down, you can move on to practicing trading using a good broker with a demo account that will help you understand things like asset classes, order types, and volatility.
The point is to read and learn about how the markets work to make educated decisions based on what you know.
#2 Seek expert investment advice.
No matter how much you read and learn about the stock market, it’ll be very difficult to cover all the angles to minimize the risk of losing money. This is why it’s still a good idea to seek counseling either from a financial advisor who specializes in 401(k) or from experienced traders who can provide investment recommendations to help you make your savings grow.
Many of these experts offer investment newsletters to analyze the markets, the economy, and more to come up with custom-tailored suggestions about where it is best to invest your 401(k) contributions.
#3 Keep cash reserves on hand for emergencies.
One of the worst things you can do to your 401(k) is to withdraw early, and, sadly, this becomes common during market crashes. Unfortunately, withdrawing your money before retirement usually means paying a penalty fee, plus your 401(k) will lose its longevity.
One way to avoid the temptation of reaching for your retirement fund during an emergency is to have an emergency fund, in cash, for when things get tough.
If you’re wondering how much you should set aside, it should be enough to get you through a few months in case you get laid off and can’t find another job, get hurt and can’t work, or experience another unforeseen life event.
#4 Diversify, diversify, diversify.
Diversification is by far one of the best ways to shield any investment from economic downturns such as a stock market crash. The idea behind diversifying your portfolio is that you’re not too reliant on one type of investment but instead spread the risk across several types. That way, if one asset or even an entire asset class performs poorly or even crashes, the rest of the assets are likely to dampen the blow.
Diversifying can be daunting if you have to choose every asset individually. Index funds are suitable investments for many people with small portfolios who want low-cost diversification without worrying about choosing individual stocks themselves.
#5 Choose your asset mix carefully.
It’s essential to think about your asset mix, which simply means the different types of investments that go into your portfolio. For example, investing in stocks may help you grow your retirement fund faster, but if they drop substantially, you could also see plenty of losses. That’s why it’s essential to choose your asset mix wisely and make sure there are different types of investments in your portfolio.
Some tips about how to choose assets are:
Invest more in stocks when you’re young.
When deciding how to allocate your funds, a general rule of thumb is that the younger you are, the more you can invest in stocks. This is because stocks offer much higher returns than other assets and have always shown a historical tendency to go up. However, they can also crash the hardest, which is unacceptable for someone who is reaching retirement age.
However, if you’re young, you can afford to take on more risk and even some temporary losses because it’s almost a certainty that stocks will end up climbing again in the future. If you keep a long-term mindset, you’re bound to end up winning in the end.
As you get older, choose safer investments.
Investing in low-cost index funds will provide you with an average return without taking on too much risk. But if you really want to reduce risk as much as possible, investing in bonds or bond funds rather than stocks or stock funds is the way to go.
#6 Rebalance your portfolio frequently.
Rebalancing is the act of restoring an asset class to its original percentage after it has changed due to investment transactions. So, for example, if you own 25% in US stocks and they increased in value, you would sell some of those stocks and invest the proceeds in other asset classes until you have 25% in US stocks once again.
Rebalancing your 401(k) portfolio is important because when one asset class increases in value while others remain constant or decrease, your original mix of asset classes changes. This affects your portfolio’s asset allocation and therefore alters the risk associated with it.
Consider the example at the beginning of this section. If US stocks go up and you don’t rebalance, you’ll end up with a portfolio that has a higher proportion of US stocks compared to your original mix. But, conversely, if there’s a market crash afterward and US stocks suddenly go down, your 401(k) will suffer more simply because it had too many stocks.
But if you rebalance before the crash, then the effects won’t be as bad thanks to the other assets you bought when rebalancing your portfolio, which could even counter the loss.
#7 Consider taking out a permanent life insurance policy
If you want to protect your 401(K) from a stock market crash, consider taking out a permanent life insurance policy. Permanent life insurance or whole life is often more expensive than term life but has the advantage of producing tax-free income and avoiding probate.
How does whole life insurance work?
A permanent whole life insurance policy guarantees that a death benefit will be paid no matter when in your lifetime you die. This death benefit will produce a stream of lifetime guaranteed cash value. In addition, this guarantee allows you to borrow against the cash value without paying any interest on the loan.
In other words, if there’s an economic downturn and you need money for your family, you can borrow against the policy tax-free and avoid the temptation to withdraw from your 401(k).
The cash value also provides your beneficiary with a death benefit which will avoid probate. This means that it’s simpler to transfer your assets to your successors faster because there won’t be any need for court proceedings or legal documents.
The Bottom Line
As you can see, there are many ways to protect your 401(k) from a market crash. First, you should educate yourself about the stock market and how it works. This will help you know what kind of investments work best for your risk tolerance. Diversifying across different asset classes is also important because this will help reduce your portfolio’s volatility.
At the same time, it will still provide some exposure to stocks, which have historically shown higher returns than other assets.
Rebalancing on an annual basis is another way to do just that by making sure all of your asset classes remain at their original percentage in relation to one another.