When the market is in a down cycle, it’s normal to feel anxious about your 401(k) or other retirement investments.
Should you worry about what the market did today? The answer depends on several factors, including your proximity to retirement, your tolerance for risk, and your skill and experience with stock analysis.
Long-Term Investors and Stock Market Dips
If you are more than 10 to 15 years from retirement and investing for the long-term, you probably don’t have to worry about what the market does on a given day.
The key to long-term investing is defining your risk tolerance beforehand and building a portfolio that you are comfortable with. It’s called asset allocation, and once you’ve settled on it, you don’t need to worry unless your allocation gets completely out of whack.
Many financial professionals will tell you that asset allocation and regular portfolio rebalancing is the best long-term strategy. There’s less fretting involved.
Instead of randomly following the market, you can set a date once a year to check in and see if your portfolio is still in line with your goals. If not, then rebalance.
Rebalancing involves selling winning investments to put more money into investments that have gone down, also known as buying low and selling high.
Say you have a portfolio that’s 70% stocks and 30% bonds. If bonds have a great year and stocks fall, your balance will change. If bonds begin to represent 37% to 63% for stocks, you can move more money into stocks to rebalance.
If you are following this strategy, you don’t really pay attention to the market for the rest of the year. Ups and downs will happen, but if your asset allocation is on target, you can ride out market swings.
What to Do If You're a Near-Term Investor
You may have a greater percentage in fixed-income or dividend-paying investments in an attempt to increase the income that your portfolio produces. But once you have an allocation that works for you, the rebalancing strategy is the same as a long-term approach.
Try to check in on your portfolio more than once a year. In doing so, you may decide to make a move if the market goes down more than a set percentage or dollar amount. This is known as a “trigger.”
Some brokerages allow you to set up text or e-mail trigger alerts and will contact you in the event of a price movement, so you don’t have to think about it until then.
One of the age-old rules of thumb for asset allocation in a near-term portfolio is subtracting your age from 100, putting your age in bonds and the rest in stocks. This may work for conservative near-term investors.
How much risk you want to take with stocks depends on your own appetite for growth and tolerance for risk. You can find many risk tolerance calculators on the web, and your 401(k) administrator probably has some tools to help you.
You can also consider whether you want to keep the stock portion of your portfolio in one broad market index fund or divide your holdings between mutual funds or ETFs, which represent different market segments and sizes, and individual stocks.
Short-Term Investors and a Down Stock Market
In general, short-term investors enjoy watching the stock market on a daily basis. Most people don’t. But if you do love it, you might make money doing short-term buying and selling individual stocks and other securities.
Don’t risk your retirement money on short-term investing until you are very sure of yourself, as the potential for losses is more probable than what a long-term investor would see.
To avoid exposing your retirement accounts to risk, you could build a “fun money” portfolio for stock trading. You’d fund this portfolio with money you don’t mind losing and is separate from your retirement account.
Another short-term, high-risk strategy is to attempt to time the market. Investors who have the most success typically buy rather than sell on market dips.
Of course, this all depends on the health of the company behind the stock. Active traders should learn how to analyze stocks based on the business’ fundamentals. If the company has strong long-term prospects and is a good value, buying it when it’s cheap is like finding a great bargain.
Real short-term or “day traders” have all sorts of tricks, like shorting stocks and making a lot of intra-day moves. Again, unless you really know what you’re doing, you could lose a lot of money attempting this (and even when you do know what you’re doing), especially if you use leverage, or debt, to trade equities. There are also tax consequences to these trades.
The Bottom Line When the Stock Market Is Down
If you’re a decade or more away from retirement, you’re probably able to ride out stock market dips because of your asset allocation and long-term plan.
Conservative near-term investors may not feel the sting of a market drop as much as more aggressive investors.
Short-term investors stand to face the sharpest losses amid a market dip, as their investment choices tend to expose them to higher levels of risk.