How to Protect Your 401(k) From a Stock Market Crash?

Making sure you have enough money for retirement is the primary goal of contributing to a 401(k). Your 401(k) will inevitably go through a series of ebbs and flows throughout your working years. Some years you’ll see tremendous growth, others you may even lose money. However, as you near retirement, you’ll want to protect your 401(k) from down years, even a stock market crash.

To protect your 401(k) from stock market crash, invest more in bond, which has a lower rate of return but also much lower risk. To gain as much value as you can, investments heavier in stocks give you the best chance of multiplying your money. However, with stocks comes increased risk. Shifting the percentage of your investments to a more bond-heavy allocation can help shield you if the stock market crashes as you get closer to retirement.

Capturing as much of the good times as possible while avoiding significant losses isn’t an exact science; there are strategies to help shift the odds in your favor. Let’s take a look at the basics of investing your 401(k), so you can protect your retirement nest egg.

Understanding the different investing options.

The average 401(k) plan provides about 19 different investment options to choose from. Unless the plan has a default investment option, your contributions could sit in your 401(k) as cash without being actually invested in anything.

If your contributions are automatically invested in a particular fund, you can always change what your money is invested in. If your 401(k) plan has an online portal, then you can research different funds and move your money as you please. If not, you’ll have to contact your plan’s custodian to facilitate moving your money to other investment options.

Your 401(k) plan’s summary plan description will outline the default investment options, the other available investment options, and how to move your money to various funds. Some of the most common funds provided in 401(k) plans are target-date funds, mutual funds, index funds, and bond funds.

Target-date funds

Target-date funds are the most common investment in which 401(k)s are invested. A target-date fund uses the account holder’s birth date and estimates the year in which they will retire. Then, the fund shifts the different assets the fund is invested in to match the risk tolerance as they near retirement.

A target-date fund will be invested in both stocks and bonds. Early in the account holder’s career, the fund will be invested more heavily in stocks, say 70/30. As time goes on, that ratio begins to shift more towards bonds. When the fund gets within a few years of the target date, it may be investing 80% of the money into bonds. This option is excellent for 401(k) holders who don’t know much about investing and would rather take a passive approach to retirement investing.

Most 401(k) plans use target-date funds as their default investment option. Contributions get automatically invested into these funds without the account holder having to do anything.

Mutual Funds

Similar to a target-date fund, a mutual fund is made up of a pool of money collected from many investors to invest in securities like stocks, bonds, and other assets. These funds are actively managed by a professional who buys and sells securities within the mutual fund.

The goal of a mutual fund manager is to “beat the market” and make as much money for the investors as possible. However, there is a cost to having somebody manage a mutual fund. The average expense ratio for mutual funds ranges between 0.5% and 2%.

Lastly, mutual funds don’t automatically reallocate the assets to match your risk tolerance. If you’re nearing retirement, mutual funds may no longer be the best option as they may weigh heavier towards stocks.

Index Funds

Index funds are a package of stocks that mirror a specific swath of the stock market. For instance, an S&P 500 index fund holds stock in every company listed on the S&P 500.

By investing in an index fund, you hedge your investments over a broader range of stocks and industries. If a particular company or sector loses value, the index fund will perform relatively well because it was invested in many other companies.

Another benefit to index funds is that they usually don’t charge that much in fees. The average expense ratio for index funds is below 0.2% and usually comes in well below 0.1%.

Bond Funds

A bond fund is a group of investment vehicles that invest primarily in government, municipal, corporate, and convertible bonds, as well as other debt instruments like mortgage-backed securities.

While bonds don’t return a substantial amount of interest, they perform reasonably well when the stock market is in a downturn. Investing in bond funds, especially when nearing retirement, is a good way to protect your 401(k) from a stock market crash.

Time is your friend.

When it comes to saving for retirement, the longer your money is in your 401(k), the better. This allows your money to grow more over time, but it also helps your money recover from periods of decline.

It’s normal for you to see your 401(k) lose value at certain times. Your mutual funds may not perform as well, the stock market dives or your 401(k) may need reallocating.

If your 401(k) is invested heavily in stocks at the beginning of your career, a stock market crash or recession isn’t the end of the world. You’ll still have years for the economy and your 401(k) to recover.

For example, when the stock market crashed in 2008, the S&P 500 dropped 38.49%. However, since then, the S&P 500 has risen 448%. Those who saw their 401(k) lose tremendous value in 2008 have seen their retirement accounts not only recover but soar way past pre-recession values.

Don’t panic when your 401(k) loses value.

It’s natural to freak out when your 401(k) loses value. Checking your 401(k) balance and seeing you’ve lost hundreds or thousands of dollars in a few months is never fun.

However, what you don’t want to do is panic and make any changes in the moment.

It may seem counterintuitive, but during a stock market crash, the last thing you want to do is take money out of your 401(k). The reason is that you paid a price for the stocks, mutual funds, and index funds you’re invested in. If they lose value and you sell, you sold your investments for a loss. In fact, the best strategy is to invest even more money into the funds you’re invested in because you’ll be paying a discount for the same funds because they’re lower in value. And because time is on your side, the funds will recover long before you’ll need to start taking distributions during retirement.

Shift your asset allocations as you near retirement.

So we’ve covered the different investment options, how time is your best strategy to weather the stock market storms, and what to do if the stock market does crash. But the absolute best way to protect your 401(k) from a stock market crash is to limit your risk from one the closer you get to retirement.

Obviously, no one can predict when the next stock market crash will be. So the next best option is to limit the effects of one on your 401(k) when you don’t have as much time to recover before retirement.

If you’re invested in a target-date fund, your investments should already be reallocated to less risky funds, like bonds, the closer you get to 65. If you’re invested in index funds or mutual funds, you’ll need to move your money to safer investments yourself. As mentioned earlier, if your 401(k) provides an online portal, it’s easy to reallocate your assets to lean more towards bonds. If not, your plan’s custodian will be able to facilitate moving your money to other investments within the plan.

If your plan doesn’t provide investment options that don’t satisfy your goals, you can roll over your 401(k) to an IRA at an outside institution. These investment institutions like Fidelity have seemingly endless investment options to choose from within their IRAs.

By transitioning your investments to less risky bond funds, your 401(k) won’t lose all of your hard-earned savings if the stock market crashes.

So what should you do right now to protect your 401(k) from a stock market crash?

Protecting your 401(k) from a stock market crash will depend based on where you are in your career. If you’re younger, you can keep investing more in stocks because you have time to recover from any downturn. If you’re older, moving your money into government and municipal bonds will help shield most of your money from the volatility of the stock market.

Remember, time and consistency will help your 401(k) grow. If the stock market drops, keeping your money in your 401(k) is the best strategy. You’ll not only prevent you from cashing out your investments at a loss but will also see your 401(k) grow when the stock market recovers.

Consider talking to your plan’s custodian or a financial planner as you near retirement. You’ll be able to get expert insight on how to best protect your 401(k) from a stock market crash.