Toughing out market ups and downs
It may be painful to watch your 401(k) value plummet when the market takes a hit, but don't press the panic button.
(Money Magazine) -- Question: I'm 23 years old and over the past couple of weeks I've seen a significant decline in my 401(k) value, so much so that a month ago I was up 12 percent on the year, and as of yesterday I am down 3 percent for the year. Should I be changing my current aggressive 85 percent stock allocation during these uncertain times or just stick with the current plan?
The Mole's Answer: Absolutely stick to the current plan. Seeing your portfolio drop by about 15 percent is painful, and you may be feeling the urge to bail out of stock funds and run toward safety. Perfectly natural as that feeling may be, it's also likely to hurt you in the long run if you act on it.
But let me digress a moment about human investing behavior. Behavioral finance studies have shown that a dollar lost hurts about twice as much as the pleasure you receive from a dollar gained. Thus, that loss you experienced is causing real pain and whenever we feel pain, we want it to stop.
In this state of mind, you may think that the best way to ease the pain is to sell the stocks and invest in government bonds and money markets. My advice is "don't do it!"
The behavior noted above is known as loss aversion. Its destructiveness lies in its ability to cause us to sell an investment after it has gone down. We have a tendency to feel very confident in up markets and then panic and sell at the wrong times.
We saw this in 2002, when there was more money draining out of stock mutual funds than any year in history. That was the year the U.S. stock market was down nearly 50 percent. At a time when investors could have been buying stocks at half price, they were doing just the opposite and selling in record numbers.
Telling you to stick to your plan and continue buying stocks does not mean I think stock prices are going up next month. In fact, I have no clue how stocks are going to perform next month, or even next year. There are, however, a few things I do know that are far more important.
First, I do know that since your portfolio is now down about 15 percent from last month that you have the opportunity to buy the same investments for 15 percent less than you paid last month. And any opportunity to buy low is a good thing.
Second, I know that the stock market works in the long run. In fact, the worst the stock market has ever done over any 30-year period is to beat inflation by 2.6 percent annually. "Safer" investments, such as bonds and U.S. Treasuries, on the other hand, have lagged inflation. Time is on your side. Since you're only 23 years old, you have an investment horizon greater than this 30-year period, and plenty of time to ride out the market's ebbs and flows.
Finally, I know that time in the market is far more important than timing the market. While I agree that we live in uncertain times, I'm not sure there is such a thing as certain times. Uncertainty is usually the reason most of us sell after the market has gone down. Moving in and out of the market is very likely to decrease your returns.
I don't know if the 85 percent stock allocation is right for you, but I do believe you should select an allocation that meets your willingness and need to take risk, and then stick to it.
In good times, don't get greedy and move into the market. In bad times, don't panic and get out of the market. Try to find the stock funds in your 401(k) that offer the lowest costs and broadest exposure to U.S. and international stock markets.
It's natural to feel some pain when the market goes down. So my advice is to think of it as a "no pain, no gain" opportunity to buy more of your equity funds at a lower price. Uncertain times are a certainty, and buying on sale is a very good thing.
Ask Money Magazine's undercover financial planner a question. Send e-mails to: firstname.lastname@example.org.
The wrong place to find income for life
Protect your family without breaking the bank
Planners preying on military personnel
More from the Mole in Money Magazine:
Kicking the fund-trading habit: If you're not getting good results, and you're not even having fun, active investing is not for you.
Payday for financial planners: Plenty of clients with plenty of cash and a shortage of advisors. That means clients will have to be even more watchful.
Where planners (sort of) get it right: Diversification. Risk tolerance. Planners are sounding the right notes, but missing the big picture.