6 Tips for 401(k) Investing in Today's Volatile Market

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
Updated March 3, 2009

How does today's volatile market impact your retirement savings?

For many people, their employer-sponsored 401(k) plan is their primary or only source of retirement savings. If you participate in such a plan, congratulations. By participating, you've taken an important step toward securing your financial future. You may not realize it, but you've also got a new name: You're an investor.

I mention this because it's an uncomfortable time to be an investor. You may be grappling with big swings in the rate of return you're earning on the investment choices you've made. There's a good chance that if the choices you've made invest in stocks, then their value has dipped recently.

For those of you who are older and nearing retirement, you may be concerned that a lifetime of work intended to culminate in a pleasant retirement is now threatened.

I'd like to offer some perspective on the current environment and make some recommendations for how to assess your situation.

Keep doing the right thing.
Don't succumb to the market roller coaster.
Think about risk.
Rebalance your investments.
Take a close look at your account.
Treat your account like a lockbox.

1. Keep doing the right thing
Continue to make contributions to your retirement accounts. Our economy isn't the greatest right now, but the fact remains that practically all of us will retire from the work force at some point in our lives. Even those of us who love work and can't imagine doing anything else will come to a point where we can't work any longer.

We need to be pay for our lifestyles during our retirement years somehow, and I believe Social Security is simply not going to cut it for most of us. That means we need a backstop, and that backstop is our own savings and investing.

Let's take a look at a hypothetical example of the importance of regular saving and investing.

Progress toward goal more important than short-term performance
Hypothetical saver starting out in 1973 followed plan¹

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc.

The chart tells the story of a 25-year-old in 1973 who got a job making $18,580 per year and saved 10% per year. This particular individual received a 3% cost of living increase every year, and a 10% promotional increase once every five years. The savings were invested in a diversified portfolio of stocks until age 55 (2003), when he began to reduce his equity exposure because he was nearing retirement.

By sticking with the savings plan through thick and thin, and keeping that portfolio invested in stocks, despite the big short-term swings in value, this saver, under these hypothetical assumptions, had an account value of about $800,000 by year-end 2008.

Everyone's situation is different, and this is merely one example, but this saver displayed particular traits that I believe are associated with long-term investing success. More importantly, these are traits that I believe you can replicate and use to improve your situation whatever your particular facts and circumstances may be.

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2. Don't succumb to the market roller coaster
It is common for people to have an emotional reaction to the market's ups and downs. This chart shows how investors' emotions change as markets move through their normal cycles.

Chart: Market's emotional roller coaster

Chart: Market's emotional roller coaster

The important thing for you to take away from this chart is that the emotions follow the movement in the market. As prices go up, we feel good about ourselves. Optimism turns to enthusiasm, then exhilaration and peaks at euphoria. Inevitably, markets move both up and down. During the downward swings, our emotions turn darker, and they seem to be at their worst―despair―when the market news is the most bleak.

Many studies have documented how individual investors, and even professionals, chase performance. When markets are doing well, investors get less concerned about risk and put their money to work in investments that have been doing well recently. Too often that means investing while looking through a rearview mirror. In the real world, that simply doesn't work out too well.

One recent example of this behavior was during 2006 and 2007. The stock markets in other countries were performing quite well. When we looked at mutual fund investors as a whole, almost all of the money that was going into stock funds was going into funds that invested in foreign stocks. This happened just in time for foreign stocks to do extremely poorly in 2008—in fact, much worse than U.S. stocks.

Now, don't get me wrong. Generally, if you have money available, I think it's a good idea to take some of your account and invest it in foreign stock funds as a way of diversifying away from any bad markets in the United States, but it's all about finding the right balance. Good investing is rarely about having an all-or-nothing attitude, but that's exactly what often happens when investors are always looking at yesterday's good ideas.

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3. Think about risk
Investing is always about finding that delicate balance between our desire for high rates of return with the dread and pain that comes from losing our hard-earned money. Determining the level of risk you're comfortable with is incredibly difficult and sometimes is revealed only when rough times, like now, arrive.

My general rule is that if you can't sleep at night because you're worrying about your investments, then you're probably taking on too much risk. But before you make dramatic changes to your investment allocations, keep in mind that determining the right level of risk for your portfolio shouldn't be solely driven by whether big swings in the value of your portfolio bother you. Your capacity for risk matters, as well.

Capacity refers to whether your financial situation allows you to take risks. For example, I generally encourage younger investors to be more aggressive because they have decades to
make up any losses. Here's why.

Lengthening holding period may reduce downside risk
Diversified equity portfolio as represented by the S&P 500 index (1926–2007)

Chart: Lengthening holding period may reduce downside risk

Chart: Lengthening holding period may reduce downside risk

Source: Schwab Center for Financial Research with data provided by Standard and Poor’s. Every 1-, 3-, 5-, 10-, and 20-year rolling calendar period for the S&P 500 index was analyzed from 1926 through 2008. The highest and lowest annual total returns for the specified rolling time periods were chosen to depict the volatility of the market. Returns include reinvestment of dividends.

This graph shows the ranges of return on stocks based on different lengths of time for holding those stocks. These ranges were calculated based on the historical experience for the U.S. stock market from 1926 to 2008. If you need to pull a large amount of money from your investments within the next year, the stock market is not a wise place to put it. As you can see, during short periods of time, stocks have sometimes done incredibly well and, at other times, have done poorly.

For those investors who are able to commit their money in the market for longer periods, the results have been much better. For example, the worst five-year period in the stock market had an annual average return of negative 12.5%. But when we look at all the five-year periods, 87% were positive, 97% of 10-year periods were positive, and since 1926, there's never been a 20-year period where stocks lost money.

For younger investors, a heavy dose of mutual funds that invest in stocks will usually make sense. For older investors, those who have less time to make up for any losses, it makes sense for them to be less aggressive. Whatever the right risk tolerance is for you, review the options in your plan and select the ones that makes sense for your situation.

As I mentioned earlier, in order to choose the right level of risk in your account, you ultimately need to make a choice regarding how much of your account value you will be investing in stocks. That's typically referred to as your asset allocation. In the example of our saver, the asset allocation was aggressive until our saver reached age 55. In other words, the money in the account was invested in mutual funds that invest in stocks. That may not be appropriate for everyone.

Let's assume that you're more comfortable with taking your account and dividing it. You decide to put some money into mutual funds that invest in stocks and the rest into mutual funds that invest in bonds, or fixed income investments. That's perfectly okay if it best matches your situation.

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4. Rebalance your investments
My fourth recommendation is to stick with that allocation by rebalancing your investments from time-to-time.

Chart: Importance of rebalancing

Source: Schwab Center for Financial Research with data provided by Standard and Poor's. Return data is annualized based on an average of 252 trading days within a calendar year. The year begins on the first trading day in January and ends on the last trading day of December, and daily total returns were used. Returns assume reinvestment of dividends. When out of the market, cash is not invested. Market returns are represented by the S&P 500 index, which represents an index of widely traded stocks. Top days are defined as the best performing days of the S&P 500 during the 10-year period.

Here is an example of why I think rebalancing is important to do. I've assumed an investor chose to place 60% of his or her account into mutual funds that invest in stocks and 40% into mutual funds that invest in bonds. If left unattended, that percentage will change over time. If our investor had selected this allocation in 1994, by 1999 the account had become 79% stocks and 21% bonds. This is a much riskier account than it was originally set up to be. It became riskier because stocks did better than bonds during those five years, and gradually came to make up a bigger piece of the portfolio.

We suggest investors rebalance their portfolios to bring them back in line with what they had originally intended. Keep in mind that a portfolio with a large percentage in stocks would probably have done quite poorly during the so-called tech-wreck in the early part of this decade.

Let's assume our investor had set up this asset allocation in the year 2000 and left it unattended. By the end of 2002, the account would have been 41% stocks and 59% bonds. This is a much lower level of risk than originally intended, and would also have been costly to the investor but in a different way. This investor, by not having enough invested in stocks, probably would not have gained as much during the years in the middle part of this decade.

What effect could rebalancing have on risk and return over time? In this example below, look at the effect that an annual rebalancing strategy had on the risk and return of a portfolio over a long period of time.

Rebalancing annually can lower risk and enhance returns
Moderate asset allocation (1970-2008)

Chart: Rebalancing annually can enhance returns and reduce risk

Chart: Rebalancing annually can enhance returns and reduce risk

Source: Schwab Center for Financial Research with data from Morningstar, Inc. The Moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds, and 5% cash investments. The indices representing each asset class are S&P 500® Index (large-cap stocks), Russell 2000 Index (small-cap stocks), MSCI EAFE Net of Taxes (international stocks), Barclays Capital U.S. Aggregate Index (bonds), and Citigroup U.S. 3-month Treasury bills (cash investments). CRSP 6-8 was used for small-cap stocks prior to 1979, Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976, and Ibbotson U.S. 30-day Treasury Bill Index was used for cash investments prior to 1978.

The brown bars represent what happened with a portfolio that was never rebalanced. The orange bars show what happened when this investor rebalanced once per year. On the left-hand side of the chart are bars showing risk levels. In this case, risk refers to how volatile the account value was. The rebalanced portfolio was less volatile, which I think most of us would agree is a good thing.

On the right-hand side of the chart are bars showing the return level. The rebalanced portfolio had slightly better returns. In this example, you're able to see why we think rebalancing makes sense, because under certain conditions it can lower risk and increase return.

Rebalancing does require effort on your part. It requires you to periodically monitor your account and adjust either the amount you have invested in different investments, or to change how new contributions to your account are allocated. To make this process easier, your plan may have an investment choice where rebalancing is done for you automatically.

Periodic rebalancing is always a good idea, but it is particularly appropriate right now. Since the latter part of 2007, the stock market has taken investors on a wild ride. It would not surprise me if you were to take a look at your account right now and find that it is out of balance and deserves some attention.

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5. Take a close look at your account
While you're rebalancing your account, take a close look at what's in it. When you allocate your contributions, which investments are they going toward? Do you still feel good about those choices? Your plan might have added new choices since you enrolled. Now is a good time to take a look at those new choices and see if any of them make sense for you.

It's also a good time to take a look at your contribution level. Does that level still make sense? For example, one suggestion I make to investors is to reconsider their contribution rate whenever they get a boost in their wages. Let's say you contribute 5% of your pay to your 401(k) account. You then receive a 3% pay increase. I recommend taking part of your pay increase, for example, one-third of it, or 1%, and boosting your contribution rate to 6%. Doing this allows you to enjoy your good fortune today, and also helps secure your future.

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6. Treat your account like a lockbox
This year continues to prove tough for many working families. In times like this, it's tempting to tap into your retirement savings accounts but the penalties and taxes will cost you in the short and long term.

Treat your retirement accounts as a lockbox, only to be opened when you reach retirement. Every one of us encounters unexpected financial difficulties at one point or another during our lives, including unexpected medical bills. In order to build sufficient wealth so that we're able to retire we need to, as much as possible, emulate the saver we looked at earlier. That saver built wealth because through thick and thin, the contributions continued and he resisted the urge to withdraw from the account when times were tough.

Realistically, it's impossible for me to sit here and say never touch the money in your 401(k) account prior to your retirement. It would be terrific if our lives played out in such a fortunate fashion. I do think, however, that withdrawing money from your retirement account should be a last resort.

Withdrawing money from a retirement account is very expensive, and, therefore, is a costly source of money. For example, if you withdraw money from a 401(k) prior to age 59½, not only do you need to pay taxes on the amount you withdraw, but you also owe a 10% penalty for withdrawing early.

Think about that for a moment. Imagine you have a $20,000 balance in your account and withdraw it all for some reason. You don't get to keep the full $20,000. If you're in a 20% tax bracket, you have to pay $4,000 in taxes plus another $2,000 in penalties. Suddenly, your $20,000 has shrunk to $14,000.

Time is our most precious asset, and stock markets can move with amazing speed and direction. What surprises many investors is that the stock market is forward-looking. It moves based on what conditions savvy traders think will occur in the future.

For example, we've been in a recession for 16 months. It seems like a bad time to be invested in stocks, right? That's true up to a point. If we knew with perfect foresight that a recession was coming, it would make sense to avoid stocks. Unfortunately, that kind of crystal ball insight is a far rarer commodity than is generally supposed.

What matters for stock investors right now is when we'll get out of this recession. If history is any guide, the stock market will start recovering well before the economy itself starts turning around.

As you can see in this table, when that happens, the stock market tends to move up quickly.

Chart: S&P 500 Performance Following Recession Lows

Chart: S&P 500 Performance Following Recession Lows

Source: Ned David Research, Inc. Gains represent increases in S&P 500 index from the "low date" indicated in the left column.

In my experience, too many investors wait to get back into the stock market until after the economic storm clouds have cleared. Unfortunately for them, by waiting for the all-clear sign, much of the opportunity for gain is no longer there. If you're investing in equity mutual funds, resist the temptation to try to time the market by jumping out of those funds and trying to get back in at just the right time.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

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1. The chart illustrates the growth in value of saving 10% of annual salary invested according to the Schwab Aggressive Model Plan until age 55, when the allocation shifts to the Moderate Model to align with his change in risk profile. The saver is a 25-year old in 1973, whose 1973 salary of $18,580 is assumed to grow at 3% annual inflation and an additional 10% due to promotion every 5 years to reach $100,000 in 2008. The asset allocation plan is weighted averages of the performance of the indices used to represent each asset class in the plans and are rebalanced annually. Returns include reinvestment of dividends and interest. The indices representing each asset class are S&P 500® Index (large-cap stocks), Russell 2000 Index (small-cap stocks), MSCI EAFE Net of Taxes (international stocks), Barclays Capital U.S. Aggregate Index (bonds), and Citigroup U.S. 3-month Treasury bills (cash investments). The Aggressive allocation is 50% large-cap stocks, 20% small-cap stocks, 25% international stocks, and 5% cash investments. The Moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds, and 5% cash investments. CRSP 6-8 was used for small-cap stocks prior to 1979, Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976, and Ibbotson U.S. 30-day Treasury Bill Index was used for cash investments prior to 1978.

Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision.

The information provided here is for general purposes only and should not be considered an individualized recommendation or personalized investment advice that any particular investor should purchase or sell any particular security or pursue any particular investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making an investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not intended to imply future results. Past performance is no guarantee of future results.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Data and news reports for certain content herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment manager.

Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

Past performance is no indication of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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