Friday, October 10, 2008

Tips for 401 (k)s in a Down Market

Tips for 401(k)s in a Down Market

During uncertain economic times, participants in defined contribution retirement savings plans—such as 401(k) or 403(b) accounts—may feel tempted to make immediate and drastic adjustments to their portfolio accounts. Such knee-jerk reactions are understandable—few things can invoke panic like the thought of losing everything you’ve worked to build.

Be Patient—These Are Long-term Growth Vehicles

But the truth is, defined benefit plans are designed for long-term, tax-deferred accumulation. And with many companies providing a “company match” percentage of what you contribute, such plans can be an ideal vehicle for retirement savings. And, generally, being in the market pays off. According to market historians, the stock market has registered twice as many positive return years as negative, and in the 57 positive years since 1926, 47 have yielded double-digit returns for investors.[1]

In addition, defined benefit contribution plans have built in features—such as asset allocation and diversification capabilities—that can help ride out market waves and maximize many savings opportunities.

Dollar Cost Averaging May Help Reduce Overall Risk

Since automatic pre-tax withdrawals are paid into your 401(k) accounts on a regular basis—usually with each check—you are already enjoying dollar cost averaging. Dollar cost averaging is a systematic, disciplined approach, whereby you invest the same amount of money at regular intervals, rather than trying to time the market. When the market is down—along with stock prices—your money will buy more shares. When the market is up, you buy less. The bottom line: with dollar cost averaging, you are never “out of the action.” And over time, the purchase of shares at regular intervals can help smooth out the impact of short-term market fluctuations.

Keep in mind, however, dollar cost averaging does not assure a profit, nor does it protect against loss in a declining market. To be effective, there must be a continuous investment regardless of fluctuating price levels. Investors should consider their financial ability to make purchases through periods of low price levels.

Know Your Risk Tolerance

Knowing your financial risk tolerance is crucial when assessing how to manage your money. Regardless of how the market performs, some people are more comfortable with risk than others. Regardless, it is prudent to review your portfolio once or twice a year. Making changes to your account in response to a specific market turn is not necessarily advisable, but a balanced 401(k) requires a balanced, informed perspective.

Asset Allocation Is Key

In addition to knowing risk tolerance, a balanced 401(k) includes a mix of stock and bond funds. And within stock funds, you’ll want to combine growth, value and large cap funds with some mid cap and smaller funds. This way, you spread risk amongst a variety of investment categories, which can help to safeguard against being hit too hard if one fund doesn’t perform as hoped.

The “Age Percentage Equivalent”—A Strategy that Can Grow with You

Here’s a general approach: consider allocating the percentage equivalent of your current age into more conservative vehicles. In other words, a 25 year-old with the time to ride out market fluctuations can consider investing 75% in riskier funds, thus allocating 25% (the equivalent percentage of his/her age) into more conservative choices. As that person nears age 50 s/he could equally split the risk between more growth-oriented funds and bond-type funds.

By the time that person is 65, it may be a good idea to have 65% of assets in safer vehicles, while still leaving 35% to achieve potentially higher returns in riskier vehicles. By following a strategy similar to this, you can enjoy the benefits of diversification while adjusting your portfolio to suit your age, goals and current situation. It’s also a way to help ensure that your assets aren’t all invested in a down market just as you’re preparing to retire.

It’s Your Future

Defined benefit plans are a wonderful way to save for retirement and benefit from stock market potential simultaneously. But as with any investment, you want to make the right choices. By understanding your risk tolerance, taking advantage of dollar cost averaging, making careful diversification choices and adjusting those choices as needed, you can help ensure that the funds you’ve worked so hard for will be working just as hard to give you a comfortable retirement.

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