The last few months have been filled with unexpected events.
- Would you have believed someone if they told you three months ago that we would be confined to our homes with all school-aged children learning online?
- Would you have believed the number of confirmed COVID-19 cases in the U.S. exceeds 1.25 million people?
- Could you anticipate the Dow Jones Industrial Average (DJIA) falling 2,997 points on March 16, 2020, the single largest daily stock market drop since the Great Depression?
No, each of these items are unbelievable. And yet here we are. Our world has turned upside down.
Wealth-Building Principles
As a financial planner who people build wealth, many of my daily activities in a normal economic environment involve planning for unforeseen circumstances. I advise clients to save cash in an emergency fund, save even more in an opportunity fund, and maximize retirement plan savings. These actions provide peace of mind and a sense of security.
Whether retirement is near or far away, you’ve been assured that more savings now generally leads to a bigger nest egg later. You believed that diligence and determination were the keys to building wealth. You yearned to be healthy, wealthy, and wise in all facets of life.
So, in today’s uncertain economic environment, what do you do with your employer-sponsored 401(k) or 403(b) plan?
Investing Terminology
Any investment account typically has a blend of equities (stocks) and fixed income (bonds). Buying Amazon stock is synonymous with betting that the value of Amazon – as a company -- will increase over time. Unless you’re an employee of Amazon, you are unlikely to have any option to purchase Amazon within your 401(k) plan.
That’s where mutual funds come into play. You are not making a bet on an individual company; you are purchasing a basket of companies.
The application is the same for fixed income. You can buy an individual corporate or municipal bond, or you can purchase a collection of bonds (through a mutual fund) to spread the risk.
The vast majority of employer-sponsored retirement plans have limited investment options. You can buy a target date retirement fund that is directly tied to your preferred retirement date, or you choose from a small menu of equity and fixed income mutual funds.
Target-Date Retirement Funds
The most aggressive target-retirement funds (i.e. target year 2050) have the largest percentage of equities and lowest percentage of fixed income. The rationale is that equities carry more risk and more potential return. You also have a longer time to recover from market downturns, compared to someone who is closer to retirement.
When directly advising a client family on investments, I do not typically recommend target retirement funds within a 401(k) because I cannot control the percentage of equities relative to fixed income. Target-date retirement funds make it difficult to move nimbly and rebalance as market conditions change.
However, a large swath of investors are self-directed and do not have an investment advisor to assist with position selection. For these individuals, a target-date retirement fund may be appropriate when two conditions are met:
1.The underlying investment mix (ratio of equities to bonds) matches the person’s risk tolerance, AND
2.The person has the discipline to stay in a single target-date retirement fund. He will not switch to a different target-date fund when the stock market has large swings in either direction.
Let’s elaborate on the first condition. Suppose you are a really conservative investor in your early 40s, and your target retirement is 25 years away. The Vanguard 2045 target retirement fund has nearly 90% equity exposure. That’s a mismatch between your level of acceptable risk and the actual holdings in this target-date fund. You’d be better off [long-term] selecting a closer target retirement date fund such as 2035 to lower the equity exposure -- even if you still plan to retire in 2045.
Now, to the second point. Behavioral psychology tells us that it’s natural to avoid loss. Known as loss aversion, humans do not benefit emotionally from a “win” as much as they seek to avoid a loss. And as much as we want to make rational decisions, about 80% of our decision-making is emotional. Therefore, when the stock market is going down, our bodies are telling us to sell and avoid a further loss.
Behavioral Psychology at Work
Yet, timing is everything. Just as quickly as the stock market declines, it can unexpectedly deliver exceptional returns in a short period of time. You remove yourself from the potential gains if you leave the stock market and cash out. It is just like leaving a seat at a sports event before the scoring play. You need to stay in your seat in order to catch the action.
Put another way, some investors think they can ease stress by leaving the stock market. However, once the rebound begins and stock prices move up, those same investors feel stressed because they miss the early gains. You are trading one form of anxiety for another when trying to time the market.
To successfully time the market, you must make two correct decisions – when to exit the market AND when to get back in. That’s nearly impossible!
When the DJIA lost nearly 3,000 points on March 16, 2020, it experienced the largest single point daily gain (+2,113) within 8 days, too. People who turned to cash in mid-March likely missed the substantial gain on March 24th.
The daily swings we are experiencing in the stock market, also known as market volatility, are unprecedented.
Here’s the bottom line for your 401(k) plan: stay invested and consider opportunities to rebalance.
Look at future 401(k) contributions if you are still employed and contributing to your employer-sponsored plan. If your target asset mix is 70% equities and you’re down to 65% equities in your 401(k) plan, put more than 70% of your future contributions into equities. 75% would be a nice short-term adjustment.
Let’s take the above example and slightly modify it. Your existing 401(k) balance is only 65% equities and 35% fixed income. Your target asset mix is 70% equities and 30% fixed income, but you are not currently employed and therefore do not have “future” contributions. This is not the time to take the money and run. Instead, rebalance by shifting 5% of your existing 401(k) balance from fixed income to equities.
Don’t Take the Money and Run
If you lost your job and will not be returning to your employer when COVID-19 fears subside, you may be tempted to take money in your 401(k) or 403(b) plan and roll it to an IRA. I’d advise against it because of the market volatility we are currently experiencing.
Most financial institutions penalize you for leaving their company. For instance, if you have a Fidelity 401(k) and want to roll it over to a Schwab IRA, Fidelity is unlikely to let you move the positions “in-kind.” Instead, they will sell all of your positions on the day you request the rollover and mail you -- or your preferred financial institution -- a check. It may take a few weeks for the check to arrive by mail and be deposited.
What if you cashed out of your 401(k) in mid-March and didn’t get the IRA account funded until mid-April? You would have permanently locked in the mid-March losses and missed the late March and early April gains. Much of that hard-earned money gone.
In other words, wait until the stock market volatility has settled if you plan to rollover your former employer’s 401(k) to an IRA or other retirement vehicle.
We’re Here to Help
Don’t have an investment strategy or target asset mix? We work one-on-one with families to provide investment and financial advice – tailored to your family’s unique situation. I would be happy to meet you (virtually) for an initial, complementary consultation.
