What is the Biggest Risk for your 401(k)?
Marcio Silveira, CFA® , CFP®
We are experiencing exceptional turbulence in financial markets as the first quarter of 2020 has come to an end. Because of the Covid-19 Pandemic, daily moves of up or down 5% in the stock market have become common these days. This environment makes us all very fearful about the fate of our retirement savings in 401(k) plans and IRAs.
So, with all this going on, what is the most significant risk your 401(k) faces?
The vast majority of 401(k) plans feature investment options in mutual funds with broad diversification. This means that there is no excessive exposure to any single company or security. The risk that remains is mostly the risk of price fluctuations of the stock and bond markets.
There is always the risk that some active mutual fund managers make a grave mistake during a moment of crisis. There is also the possibility that some managers experience outstanding investment performance. In a plan with several investments, there is a good chance that good and bad managers cancel out.
Commonly, index-tracking funds are a substantial part of 401(k) investments. In this case, the risk of the funds is basically tightly connected with the risk of the index it tracks.
The price fluctuation risks of mutual funds are a reality, but to what extent do they really matter?
Here is the answer: The most significant risk you face is making a big mistake because of panic!
It is well documented that investors that sell stocks when the market drops fail to get back in to benefit from the upswing that typically follows a crash. It happens again and again. It certainly happened last time in 2008-2010, and it will probably happen again now.
Stocks in a retirement account are for the long term. Terrific years (like 2019) or bad years (like 2008) do not influence long term returns that much. The reason to hold stocks for the long term is that they likely provide a return much stronger than inflation, cash, or bonds.
Here are some figures to put things in perspective:
The S&P 500 year-to-date performance to March 31st, 2020, was -19.60%. This is exceptionally bad.
The total return performance of the S&P 500 index in 2019 with reinvestment of dividends was +33.07%. This is exceptionally good.
Here are some additional annual performance figures for the S&P 500 (as of April 3rd, 2020) with reinvestment of dividends (according to the Professor Robert Shiller database – Yale University).
5 years: +7.0%
10 years: +10.8%
15 years: +7.6%
20 years: +5.1%
30 years: +9.3%
The 20-year period starts at the height of the .com boom (March of 2000) and includes the popping of the tech bubble, the financial and housing crisis of 2007/2008, and the current COVID-19 crisis.
Stocks as a long-term investment make sense even in periods of crises and market meltdowns. Liquidating these investments in the middle of a market panic can be very detrimental to the long-term growth of your retirement assets.
So, in turbulent markets, protect your 401(k) from the most prominent risk by speaking with a qualified financial advisor that can help you create calm and clarity. Your older self will thank you for that!
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