Retirees are just now opening their 401(k) statements after an ugly fourth quarter and raising the inevitable question spawned by every significant market decline: should I rush for the exits?
There will be the requisite response from every financial columnist in the country and most will say, "do nothing."
Ah, if life were that easy!
Here's my alternative response. First, what you should do depends on your age and whether you are in your earning years, approaching retirement, early in retirement, or late in retirement. For those still working with at least a decade until planned retirement, "do nothing" is often a good idea. You have many years for the market to recover and to save more.
It might be a good answer for those in the other three life stages, too, but that depends entirely on your financial situation. I wouldn't hazard a suggestion without those details.
Regardless, a significant market downturn can be very educational. During a long bull market, it's easy to decide that you're a risk-taker and that a 25% decline in the S&P500 index wouldn't prompt you to panic-sell at a market bottom. But, you truly understand your risk tolerance only when the decline is actually happening.
My goal for clients is to make them so comfortable with their investments that, like me, they never even think about market downturns. If last quarter's market correction caused you significant anxiety, what it hopefully taught you is that you have too much invested in the stock market. In that case, the correct answer is to sell some of your stocks (as your stomach is trying to tell you to do) and invest the proceeds in something safer, like CDs or a short-term bond fund.
I have about 40% of my portfolio invested in equities so it is unlikely that I will lose more than 15% of my total portfolio in a severe downturn like 2007-2009. A temporary dip of that magnitude wouldn't threaten my standard of living so I ignore downturns.
A friend called this week, noted that her 401(k) had declined in value last quarter and asked what I thought she should do. Some of her colleagues were bailing out of the market but her inclination was to do nothing. She got it right. Perhaps they did, too.
The first question I asked was if she thought she would need to spend the money in her 401(k) investment portfolio anytime soon. Her answer was no, so I told her to ignore the market until she has a need to spend from her portfolio.
If you don't need the money anytime soon, then you needn't care if stocks decline in value temporarily. Those lower prices are what someone would be willing to pay for your stocks today but you're not going to sell them today.
If you have money that you will need to spend in the next 5-7 years, then it shouldn't be invested in stocks. You might be forced to sell stocks at market-bottom prices to pay those expenses before the market has a chance to recover. There is no guarantee that stocks will recover from losses in 5 to 7 years, either, but the odds are pretty good that they will.
Selling stocks and getting back into the market later is called market timing and it is a terrible idea. Research shows that hardly anyone can successfully time the market and investors who try consistently lose money. If you decide to sell because you have too much invested in the market and it's keeping you awake at night, don't be tempted to buy back in during the next bull market. That's a loser's game.
A good retirement plan, by the way, would anticipate market declines and tell you how to deal with them.
Get off the Rolaids Treadmill in two steps. Take any funds you expect to spend in the next 5-7 years out of stocks and put them in a safer place. Then make sure the amount that remains in stocks doesn't exceed your risk tolerance.
As a guideline, investing 40% of your portfolio in stocks would probably result in a 15% portfolio loss in the worst of bear markets compared to a 25% portfolio loss for a 60% stock allocation.
If you lost enough of your portfolio in the recent downturn to cause you pain, don't waste a learning experience. Fix it now. As a Senator from Kentucky likes to say, there's no education in the second kick of a mule.
And that's a record for me—a two-blog post day. You can check out the other at Forbes.com. Now, I need to soak my overworked fingertips (metaphorically) in a glass of something else Kentuckians like to say.