Your 401(k) and Stock Market Volatility

How Do You Protect Your Investments From Stock Market Volatility?

Don’t put your retirement savings in harm’s way. During a volatile market, what you do and don’t do with your 401(k) can have the biggest impact on your long-term savings goals. The most harmful mistakes to retirement savings are often made during times of heavy market volatility. In fact, bad decision making can be more dangerous than the volatile market. But why?

There can be several reasons why short-term market volatility creates such a danger zone. 401(k) investors may try to enhance their performance by timing the market or, they may focus on protecting what they’ve already accumulated.

During Market Volatility, Don’t Try To Improve The Personal Rate of Return In Your 401(k)

Who doesn’t want to see their 401(k) grow? A sudden drop in the market can either bring the cold fear of potential loss, or stoke the greed of potential gain, when an investor is looking at their 401(k) savings. But, when they try to “time the market”—which means buying and selling investments based on today’s market trends—investors are likely to lose, and lose big. In fact, there is no financial professional that I am aware of with a long-term track record of being able to consistently jump in and out of short-term market volatility successfully. And it’s even worse for individual investors.

Market research firm DALBAR’s annual “Quantitative Analysis of Investor Behavior” study shows that, over time, investors typically make the wrong decision with their buying and selling of mutual funds. Over a 25-year period that covered stocks' activity from 1993 to 2018, DALBAR found that the average stock investor had an annualized return of 6.8%, versus the S&P 500's 9.1% return during that period. Similarly, bond investors earned an average annualized return of 1.5%, whereas the Barclays US Aggregate Treasury Index returned 4.8%.

Why did individual investors make far less money than the market returned?  The answer is they made too frequent of changes and didn’t hold their investments long enough to participate in the long-term benefits. At different points in a given market cycle, investors missed gains because they wanted to avoid losses, or they took on too much risk because they were too optimistic. In other words, they tried to “time the market,” and ended up with less than they would have if they had simply left their money alone.

Keep in mind, your 401(k) plan is a long-term investment. Per the DALBAR study, people tend to only hold their stocks for an average of four years, when 401(k) stock investments are mostly designed to be held for decades. And that’s when you’ll really start to see consistent 401(k) returns, over 10- to 30-year horizons. In fact, if you look at the S&P over any 30-year period, the worst 30-year period (during the Great Depression) still had positive stock returns over 7%.¹Your long term retirement readiness comes down to the time you have in the market, not timing the market.

If You Focus on Protecting Your 401(k) Investments From Stock Market Volatility, You’ll Lose Out

A lot of individuals go into a defensive posture when they think about losing money. And it makes sense. Our brains are wired to fear loss a lot more than we appreciate gains. In fact, it’s called Myopic Loss Aversion, and Nathan Fisher wrote about it specifically when it comes to choosing funds for a 401(k) fund lineup.

Myopic Loss Aversion impacts individual investors like this: We feel losses 2.5 times more than we enjoy the same sized gains.² Essentially, we take gains for granted and worry deeply about losses.

This is where the media comes in by leveraging fear to drive ratings. And unfortunately, it’s easy to be scared—especially with headlines constantly talking about a global pandemic and the economic uncertainty it's causing. So, people decide to stop investing in their 401(k), or they sell all their stocks (lock in their losses) in a time when they should be holding. After all, gains or losses are all “on paper” until the investment is sold. As this article from Fisher Investments points out, selling out of fear not only makes it harder to reach long-term goals, but also makes it more difficult to get back into the stock market. Since investor fears typically start to subside as the market goes up, that means anyone who sold at the bottom will now have to buy in for more than they got by selling out.

The fear-based instinct can cause real problems for people down the road. If you miss just 10 of the best days in the market over a 20-year period, you lose out on 984% of your cumulative returns!³

How Do I Lower The Volatility of my 401(k)?

The primary way to lower your 401(k) volatility is through the power of diversification.  Diversification is a way to manage risk and it means having an investment strategy that spans many different countries, sectors and investment styles.  Also, as appropriate, blending other asset types such as bonds into your portfolio.

Another less often discussed way to lower your 401(k) volatility is to check your balance less often.  Daily, weekly or monthly reviews can stoke too many emotions.  Reviewing on an annual or semi-annual basis is likely all you need.  As long as nothing has changed with your financial situation and retirement goals this can avoid emotional reactionary decision making. Let time and compounding growth do their thing. The longer period you wait to look, the better your balance will likely look. You just can’t watch the ticker every day.

Here’s what I tell 401(k) plan participants: you are inherently buying stocks with every paycheck, which is every two weeks for many of us. You’re buying when the market is up and you’re buying when the market is down. The important thing for your long-term retirement is to regularly and consistently save as much as you can and invest for as long as you can so you can pay yourself in retirement. Keep the long-term perspective.

What Investors Should Do About Market Volatility

In a volatile market, the best guidance is to make sure you’re not making changes to your investment strategy based on the news headlines or your emotions. And generally, avoid making any rash decisions.  Changes should largely be based on when you have a change to your personal financial situation or goals. Even if you’re retiring soon, you won’t be pulling all of your money out of your 401(k) to use on day one. You’ll still be investing and earning money on your invested dollars for many years, likely throughout all of retirement. Remember: Historically, stocks always win over the long term.

On any given day, stocks’ upward or downward movement is difficult to predict. From a historical perspective, stocks have been positive on a daily basis 53% of the time—about a 50/50 proposition. But look at stock performance on a monthly basis, and you’ll find that returns have been more positive more than 60% of the time.⁴

And the longer you wait, the better it gets: Over rolling 10-year periods, monthly returns are positive about 94% of the time on average. And over rolling 20-year and 25-year periods, monthly returns are positive during 100% of any given period.⁵

401(k) and Stock Market Volatility

The effect of seeing your personal retirement account, or your company’s 401(k) total assets go up and down over the short term can cause an emotional reaction that alters your otherwise-disciplined decision making. But you can’t score if you pull your players partway through the game. As firm founder Ken Fisher often says, it’s not the losses that investors should be worried about—it’s missing the next big rebound that brings your account balance back up. And those big spikes are pretty much impossible to time.  

¹Source: Global Financial Data, Inc. as of 12/22/2017. Average rate of return from 12/31/1925 through 11/30/2017. Equity return based on Global Financial Data, Inc.’s S&P 500 Total Return Index.

²Source: FactSet, Inc.; as of 10/18/2018; daily S&P 500 Total Return Index from 01/01/1988 to 10/17/2018.

³Source: Source: Thaler, R. H., Tversky, A., Kahneman, D., & Schwartz, A. (1997). The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test. The Quarterly Journal of Economics, 112(2), 647-661.

⁴Source: Global Financial Data, Inc. as of 12/22/2017. Average rate of return from 12/31/1925 through 11/30/2017. Equity return based on Global Financial Data, Inc.’s S&P 500 Total Return Index.

⁵Source: Global Financial Data, Inc. as of 12/22/2017. Average rate of return from 12/31/1925 through 11/30/2017. Equity return based on Global Financial Data, Inc.’s S&P 500 Total Return Index.