Rebalancing after the panic of 2008

(Money Magazine) -- Question: During the market's dramatic drop in 2008 and the beginning of last year, I couldn't stand watching my 401(k) shrink. I didn't move the money I already had in various stock and bond funds, but I did shift my current contributions into conservative investments. I now want to rebalance my 401(k) and am wondering what my portfolio mix should be at age 42? -- Michael, Atlanta, Ga.

Answer: Your move in the wake of the stock market collapse reminds me of this quote from the late Irish playwright and Nobel Laureate George Bernard Shaw: "I'm an atheist and I thank God for it."

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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Which is to say that although you seem to have strayed from the investing strategy you set for your 401(k), you didn't abandon it entirely.

In all seriousness, though, I think there are a couple of good lessons all investors can take from your (temporary and incomplete) lapse of faith in asset allocation and, considering your intention to fix your mix, apparent return to the fold.

The first take-away from your situation is that while you certainly don't want emotions to dictate how you invest, it's unrealistic to ignore them altogether. As a rule, I believe investors are better off resisting the urge to switch their investing approach during periods of upheaval in the market.

So, assuming that you were already invested in a well-balanced group of stock and bond funds that made sense given your age, goals, and risk tolerance, I think your new contributions should have reflected the way you chose to divvy up your portfolio overall. In other words, if you've decided that a 401(k) stocks-bonds blend of, say, 75% stocks and 25% bonds, makes sense for you, then 75% of your new contributions should flow into your stock funds and 25% into your bond funds, regardless of the market's contortions.

Had you done that rather than shift your new contributions into bonds after your portfolio had taken a hit, your account balance would likely be higher today, given that stocks outperformed bonds by a margin of nearly five to one in 2009, or roughly 29% vs. 6%.

In the real world, however, it can be extremely tough to resist the impulse to do something, anything, to alleviate the pain of watching your 401(k) balance circle the drain. If you're one of those people for whom standing pat in such a situation just isn't realistic, then maybe it's better to recognize that you're going to react in some way, and then make sure you don't do anything that will inflict too much damage.

For some people, that might mean doing what you did -- i.e., letting their existing allocations ride but temporarily changing the way they invest their current contributions. Another strategy might be to set up a very small "mad money" account, which would allow you to scratch the itch to push the envelope during bull markets and hunker down in bears without making a hash of your real retirement assets. In short, the idea is to give yourself a safety valve of sorts that allows you to give vent to the overwhelming desire to take action but without sabotaging yourself.

The second lesson I think we can all take from your experience goes to the heart of your question of what your portfolio mix should be at age 42 (although the lesson applies to investors of all ages).

I normally recommend that someone with your long investing horizon -- a good 20 or more years until you retire and then another 20 or 30 in retirement -- invest predominantly in stocks. For example, the Vanguard and T. Rowe Price 2030 and 2035 target-date funds, both of which were designed to be appropriate for someone your age and which made our Money 70 roster of recommended mutual funds, have roughly 85% to 90% of their assets in a diversified pool of stocks and the rest in bonds and cash.

But it's one thing to say that someone young should have 85% to 90% of their retirement funds in stock because they have plenty of time to rebound from market setbacks, and another to actually stick with that big stock stake when the market takes the kind of huge hit it did from its high in 2007 to the low in early 2009.

Which means you've also got to take your emotional and psychological makeup into account when setting your initial asset allocation strategy. Clearly, you don't want to devote so much of your portfolio to low-volatility investments that you jeopardize your ability to build a decent nest egg. But you also don't want to be so aggressive that you'll end up abandoning stocks after the market has taken a dive (or, when you're closer to retirement, that you end up in such a deep hole after a market setback that you don't have enough time to climb out). You need to strike a reasonable balance that you can live with through good times and bad.

You don't say what your stocks-bonds mix was when the market began heading south. But the fact that you felt compelled to stop contributing to stocks and go solely to more conservative investments suggests that perhaps you overestimated your tolerance for risk. That's not uncommon during market upswings, just as it's not unusual to err on the side of security after market meltdowns.

So in creating a stocks-bonds blend for your 401(k), I recommend that you use 85% to 90% in stocks as a starting point. From there, however, you want to consider your personal situation to arrive at a mix more tailored to you.

The more upset you get at the prospect of seeing your account balance decline significantly, the more you'll scale back your stock exposure. To get an idea of how vulnerable to downturns different stock allocations can be, you can check out Morningstar's Asset Allocator tool.

At the same time, you'll want to know the effect different allocations may have on the eventual size of your account balance or on your ability to live on your nest egg once you retire. Your 401(k) may provide online tools to assist you on this score. If not, resources such as our Retirement Planner, Fidelity's Retirement Quick Check, and T. Rowe's Retirement Income Calculator can help.

No one enjoys the kind of economic and financial turmoil we suffered through recently (and are still trying to put behind us). But, at the risk of sounding Pollyannaish, such episodes can also serve as a reality check that can help us more accurately set our risk tolerance and overall expectations going forward.

So with the experience of the past few years in mind, I suggest that you go through the process I describe to re-jigger your portfolio. If nothing else, you'll be putting the painful experience of the past few years to good use.