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“The Dow Jones Industrial Average just lost 12.9 percent today”. That’s what the news reported on March 16, 2020, right at the start of the COVID-19 pandemic.
My mouth dropped and I was speechless. I’ve been through some rocky ups and downs when it came to the stock market. But this was simply unprecedented.
12.9 percent in one day? To put that in perspective, if you had a nest egg of $1 million, then you just lost $129,000 – all at once!
Every savvy investor knows that when it comes to investing in stocks, you have to be willing to accept some risk if you also want a chance at gaining some rewards.
But we’re also only human and seeing your life savings evaporate before your eyes can really cause a lot of anxiety.
That’s why in this post, I’d like to talk about what you can do to protect your retirement savings from a stock market crash. We’ll go over some steps you can start taking now to protect yourself as well as a few strategies to help you navigate a crash once it occurs.
What Is a Stock Market Crash Exactly?
Simply put, a stock market crash is a sudden and unanticipated drop in stock prices as a whole. It’s perfectly normal for individual companies to fluctuate in value every day.
But when the majority of the market dives, it signals that something larger might be at play.
Usually, stock market crashes are brought on by things that affect our society as a whole like the current state of the economy, politics, wars, natural disasters, … pandemics!
2020 will be a year that every young investor got their first lesson in how swiftly a stock market crash can take place.
They can also be the result of an economic bubble that eventually collapses. This is when many people speculate on the value of something and drive its price way up.
However, when the thing they were investing in eventually doesn’t deliver, it starts to rapidly lose money and ultimately ends up dragging down other parts of the economy with it.
For instance, I was in college when the 2001 dot-com bubble burst took place. This was a stock market crash that happened because investors were pouring money into thousands of internet startup companies that produced no profits and had no clue about how to achieve long-term success.
The vast majority of them ended up filing for bankruptcy.
Several years later, I had been working for a while in my career and then the 2008 housing crisis occurred.
This was a complicated situation where lenders had started giving out mortgages to people who couldn’t afford them (called subprime mortgages), resulting in millions of people defaulting on their loans.
The ripple from these subprime mortgages caused nearly every financial institution to become negatively affected. For instance, Lehman Brothers, the nation’s fourth-largest investment bank at the time, ended up filing for bankruptcy.
It didn’t take long for the repercussions of the housing crisis to extend to other industries too. Major companies like GM and Chrysler filed for bankruptcy, and the unemployment numbers shot up as employers were looking for any means possible to stay afloat.
This went on for several bleak years that were later dubbed “the Great Recession”.
Man, did my 401k take a beating! It was a scary time for me and part of what drove me to take an interest in financial freedom.
It’s important to note that a stock market crash is different from a stock market correction. Although both can cause the market to dip, corrections are more about returning valuations to their “natural” levels as opposed to emotional reactions.
For instance, when stocks are trading at prices that exceed their fundamentals, investors might begin to slow down causing the market to go into a correction. Such an action is healthy for the economy because it helps prevent bubbles from forming (like the two previous examples).
How Will a Stock Market Crash Affect My Retirement Plan?
Unfortunately, when a stock market crash happens, it's bad for everyone all around. But in particular, for retirees or people saving towards retirement, the impact can be felt directly. Here’s how:
Reduces Your Overall Portfolio Balance
The first consequence of a market crash is that the balance of your retirement portfolio will more than likely decrease.
The magnitude of this will depend on what you’re invested in (such as having mostly stocks) and how those investments react to what’s happening to the market crash.
I can remember a story one of my clients once told me about a coworker who had amassed a nest egg of nearly $2 million before the Great Recession.
Then, about a year into the crash when the S&P 500 was at its lowest point, his nest egg had dropped all the way down to $800,000. He was devastated!
Causes You to Deplete Your Nest Egg Sooner
If you happen to retire a handful of years before a market crash, then you’re at risk that each of your annual withdrawals will have a greater percentage reduction of the overall balance than you might expect. This is a phenomenon known as sequence of returns risk.
Here’s a simple example of how that works:
- Let’s say you start with a nest egg of $1,000,000 and withdraw $50,000 to cover your living expenses. Now you’ve got $1,000,000 – $50,000 = $950,000 of nest egg left.
- The market takes a 20 percent loss. By the end of the year, you’re now left with a nest egg of $950,000 – $190,000 = $760,000.
- You make another withdrawal of $50,000 leaving you with $760,000 – $50,000 = $710,000.
- The market takes another 20 percent loss. By the end of the year, you’re now left with a nest egg of $710,000 – $142,000 = $568,000. In just a short amount of time, you’ve already watched your entire life savings deplete by 57 percent. Scary!
This is why financial experts often recommend using the 4 Percent Rule as an upper limit for making withdrawals from your nest egg.
Sequence of returns risk was one of the main factors that led the financial planner who came up with this rule, Bill Bengen, to conduct this study in the first place and arrive at the 4 percent conclusion, which states that you should only withdraw 4% of your retirement savings every year to cover your living expenses.
Tricks You into Making Irrational Decisions
Emotional investing is one of the most sure-fire ways to make a bad choice and lose a lot of money. And when it comes to a stock market crash, people tend to get very frightened and have rash reactions.
I can remember during the Great Recession, one of the administrative assistants I worked with told me that she was so spooked by what was happening that she had withdrawn her entire 401k and moved it all into her savings account.
Her rationale was that it would be better to be left with half of what she had than to potentially lose it all.
Unfortunately, that was probably one of the worst ways possible to handle the situation. The old saying in investing is “buy low, sell high”. So, when you pull your money out during a market crash, you’re doing exactly the opposite by “buying high and selling low”.
On top of that, it's important to keep things in perspective and acknowledge that market crashes don’t last forever.
Within about 3 years of the start of the Great Recession, the stock market had returned to its previous value. So anyone who did “nothing” and just rode it out eventually saw their investments return to their pre-crash values.
How to Prepare in Advance for a Market Crash
Having navigated the preservation of our life savings through two significant market crashes now, I can say I’ve learned a few pitfalls to avoid and tricks to minimize your losses.
Here are some smart preventative measures that you can take so you’ll be prepared for the next market crash.
Overshoot Your Target
Whenever I’m helping my friends to estimate how much they think they’ll need for retirement, something I like to do is add about 20 percent to that number. For instance, if someone thinks they should save up $1 million, I say make your end target $1.2 million.
Why? Because the additional funds can act as your safety margin. Using the same example, let’s say you retire with $1.2 million and then the market drops by about 20 percent in the first year.
In that case, you’d have a lot more confidence in your nest egg because you know that you really only need $1 million to start with.
Plan a Low Withdrawal Rate
Another reason to consider increasing your nest egg is that you may want to plan on using a lower withdrawal rate once you’re finally retired.
In the same study conducted by Bill Bengen that arrived at the 4 Percent Rule, it was also found that withdrawal rates as low as 3.0 to 3.5 percent had a 100 percent survival rate over 50 years.
That means if you’d like some assurance that your life savings will be able to weather every stock market crash and economic recession we’ve seen over the past century, then a lower withdrawal rate is going to do the trick.
In the same way that you can estimate your nest egg savings using the 4 Percent Rule, you can also do the same thing with lower withdrawal rates. For instance,
- If you’d like your nest egg to produce $40,000, then using the 4 Percent Rule you’d have to save $40,000 / 0.04 = $1,000,000
- However, if you’d like to be ultra-safe and produce $40,000 using a 3.5 percent withdrawal rate, then you’d now have to save up $40,000 / 0.035 = $1,142,857
In a nutshell, the more safety you’d like to have, the larger the nest egg you’ll need to plan for in advance.
Don't Invest Based on Speculation
If you’re banking your retirement dreams on cryptocurrency or the latest meme stock, then I’ve got some bad news for you.
Any time there’s a market crash, speculative investments (those based on hype rather than tried and true fundamentals) are usually the first to go. It happened during the dot-com crash in 2001, and history always repeats itself.
Instead, stick to those funds that have a track record of producing reasonable rates of return. For that, I usually look to boring but dependable index funds like those that follow the S&P 500.
Diversify Your Assets
When you’re early on in your working career, it's okay to be invested heavily in stocks because you’ll have plenty of time to ride out any recessions and make your money back.
Since the lowest point of the Great Recession, I’ve seen my stock funds go up by four times in value.
However, as you start to approach your intended retirement years, it’s a good idea to start becoming more conservative by diversifying between stocks, bonds, and other asset classes (real estate, gold, etc.).
The strategy behind this is that when stocks go down, these other assets will preserve or possibly offset some of those losses.
The classic rule of thumb is to take 110, subtract your age, and then allocate that percentage of your portfolio to stocks. For example, let’s say you’re 50 years old. According to this rule, you should put 110 – 50 = 60 percent of your money into stocks and then the remaining 40 percent in bonds.
By doing things in this way, if the market crashes, then only 60 percent of your portfolio will be affected while the remaining 40 percent will likely see relatively lower losses.
That’s going to leave you feeling much more secure about your money lasting you throughout the rest of your life than you may have previously felt.
Rebalance Your Portfolio Every Year
One of the best ways to ensure that your asset allocation stays in proportion to your liking is to rebalance it once per year. Rebalancing is the act of selling off some securities where your portfolio is too heavily weighted to buy securities where you might be a little light.
For example, let’s say you like your asset allocation to be 80 percent stocks / 20 percent bonds. If left unchecked, the stock market could go up in value and your actual allocation might change to 90 percent stocks / 10 percent bonds.
In this scenario, when the market does eventually crash, you’d ultimately lose more money than you had intended because you were too heavy into stocks. So, by periodically selling off some of those gains, you’ll keep your portfolio in balance with a mixture that you’re comfortable with.
On top of that, rebalancing also gets us back to the “buy low, sell high” mantra. By forcing yourself to sell off some of the winners and buy more shares of the funds that haven’t done as well, you’re effectively locking in your gains.
I make rebalancing simple by setting this up automatically with my financial institutions. Since everything is done digitally, near every investment provider makes this feature as simple as checking a box somewhere in your account settings.
How to Preserve Your Nest Egg During a Market Crash
It’s one thing to do everything you can to protect your money before the market crashes. But once it finally does, all it's going to take is one big stumble to get yourself into trouble and cut your portfolio in half.
The next time you find yourself in the middle of a market crash, here are some sound tips to keep your head above water and your money out of harm's way.
The worst thing you can do any time the market loses value is to freak out. Letting your emotions run rampant and making hasty decisions is a recipe for absolute disaster.
Remember: Market cycles are perfectly normal, even if they are uncomfortable. But they don’t last forever.
I thought for sure that when the COVID-19 pandemic started and the markets went into free fall with the Dow Jones losing 37 percent within the first month that we’d be heading for a possible second Great Depression.
But thankfully, things didn’t turn as bad for the economy as they could have and stocks have since recovered to new record highs.
Don't Stop Saving for Retirement
Another misstep that people often make during market crashes is that they stop contributing to their retirement plans. They, unfortunately, begin to subscribe to the false logic of “Why should I put my money into something that’s losing value?”
Yours truly made that mistake … In the years before the Great Recession, I had started a wonderful habit of taking my profit-sharing check and using it to fund my Roth IRA.
But that year, I was fearful of what was happening to the stock market and so I sat out on the sidelines. That caused me to miss out on some pretty big gains as things started to creep back up.
The problem with this line of logic is that investing when the markets are down is precisely the time you should be – when prices are at their potentially lowest points.
Even though it can be scary, most stocks are trading at a discount of what they’re probably actually worth and are likely to go back up once things begin to stabilize.
This can best be summed up in a great quote by investment legend Warren Buffett, the Oracle of Omaha: “Be fearful when others are greedy, and be greedy when others are fearful.”
If you’re already retired and the market crashes, then another strategy you can use is to adapt to the situation and tighten your belt for a few months. For instance, if you normally pull out $40,000 for your living expenses, perhaps you could try living off of $35,000 for the year.
It’s not written in stone anywhere that just because you’re retired that you have to follow the 4 Percent Rule exactly and always take out the maximum amount you’re allowed. In fact, one easy way to cut back is to temporarily not make any adjustments for inflation and keep your withdrawals at the same level as what they were the year before.
Another solution could be to find a part-time job or side hustle. By making a little extra cash on the side, you’ll be able to offset your withdrawal amount, even if it’s just temporary.
The Bottom Line
Stock market crashes are inevitable. Humans are emotional creatures and when things happen to our economy or society, our reactions can cause share prices to go into freefall.
Since most people's retirement plans consist of stock-based funds, this is going to have a profound impact. You’ll likely see your retirement savings decrease as well as the amount of money that it’s going to yield to cover your living expenses.
Whether you’re still saving for retirement or already retired, there are several things you can do to minimize your losses.
Strategies like overshooting your target, diversifying your assets, and planning a lower withdrawal rate will be very effective at ensuring your money will last. Other smart tactics like staying flexible and continuing to contribute to your retirement plans will help to ensure your losses will be minimized.
Above all, remember not to make any rash decisions. You've made it this far with your money, and as long as you stay the course, you're going to weather the storm and come out on the other side just fine.
- 21 Stock Market Investing Terms You Need To Know
- Why You Should Start Saving for Retirement Beginning Right Now
- Understanding 401k and IRA Retirement Plans