401(k): Cut losses or stay the course?

Coming up with a retirement plan involves many factors -- but don't let recent market performance affect your long-term strategy.

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By Walter Updegrave, Money Magazine senior editor

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).

NEW YORK (Money) -- Questions: I currently contribute 10% of pay to my company retirement savings plan -- my employer matches half of that amount -- and I'm heavily invested in both domestic and foreign stock index funds. I plan to retire in 16 years. Should I continue to ride out this market with risky funds or should I think about cutting back my losses? --Mike, Washington, DC

Answer: I've been getting a lot of emails in recent months from people who are anxious to "cut losses" in their 401(k) or other retirement accounts.

But as understandable as that sentiment may be, you don't want to focus just on recent losses in setting your investment strategy going forward.

That's not to say that you should ignore losses. You shouldn't (and probably can't anyway). Losses can reflect not just an overall market slide, but in some cases indicate a poor investment decision on your part, such as buying a fund without really understanding how it works or what its risks are.

And even if that's not the case, your reaction to setbacks in the value of your account is a good barometer of your true appetite for risk. That's important to know because the extent to which you can handle downdrafts in the value of your portfolio both financially and emotionally is an important consideration in developing the investment strategy that's appropriate for you looking ahead.

But dwelling on losses too much can also lead you to make some iffy moves.

For example, after getting whacked in a downturn like we've just experienced, some people get so intent on avoiding future losses that they invest far too conservatively, rushing into stable-value funds, CDs or money-market accounts. Problem with that approach is that it can seriously limit your portfolio's growth potential, which could mean having to live on less in retirement.

Other investors get so intent on making up for the money they lost that they go the other way and invest far more aggressively in hopes of racking up big gains quickly to get even. But that approach involves taking on more risk, which means you could get hammered even harder if the market slides again, putting you into an even worse position.

So what's the right approach?

Well, it certainly doesn't hurt to see if there's a way to take advantage of losses for tax purposes, although that's much easier to do with taxable than with tax-advantaged accounts.

But aside from that, your main focus should be on positioning your portfolio to give you the right balance of return and stability over the longer term, given the stage of retirement planning you're in.

That means you should be devoting your attention primarily to re-assessing whether your retirement stash is divvied up properly between stocks and bonds.

In the case of someone your age -- I'm assuming you're 50 or so -- you still need to be investing for growth in your portfolio. After all, you've probably got another 35 or more years of life ahead of you. So you need to accumulate a nest egg over the next 15 or so years that will be large enough to support into your 80s or longer.

At the same, though, you're closing in on the home stretch toward retirement. So even though you've still got plenty of time left to contribute to your 401(k) and other accounts and sufficient time to rebound from losses, you don't want to invest in a way that could put you into a hole so deep that you can't recover during your career.

Generally, someone 50 years old should have between 70% and 80% of his or her portfolio in a diversified blend of stocks and the rest in bonds. You can make a case for investing more aggressively -- say, you'll be collecting a big pension, you'll have plenty of other resources to fall back on in retirement or you're just comfortable taking more risk. And you can make a case for investing less aggressively -- you're more risk averse, you have no pension, maybe you're worried you'll be forced into retirement earlier than you would prefer. But a 70% to 80% stocks position is a reasonable starting point.

You say that you are "heavily" invested in domestic and foreign stock index funds. Heavily can mean different things to different people. But if your stock holdings are north of the range I just described, you may want to consider dialing back a bit. Even if you're within that range but are still really rattled by the recent performance of your portfolio, you may want to move toward a less stock-intensive mix (although, remember, if you get too conservative, you might regret it when retirement time rolls around).

Clearly, the reasonable range for a stocks-bonds mix is going to differ by age. People in the early stages of their career can afford to invest more aggressively because they should be concerned more with the long-term growth of their nest egg rather than protecting it from hits in the short-term. And, as I've discussed recently, someone who is close to retirement -- or already retired -- needs to be more careful about preserving their retirement assets.

To get a sense of what might be a reasonable allocation that you can make more or less aggressive depending on your particular situation, I suggest you check out the target-date retirement portfolios for your age offered by Vanguard and T. Rowe Price. These are the two fund families whose target funds we've included on our Money 70 list of recommended funds.

The T. Rowe target funds tend to be more aggressive than their Vanguard counterparts, at least in the funds geared toward older investors. So if you're looking for a more aggressive mix, you may want to use them as a guide. If you're more conservative, the Vanguard funds might provide a stocks-bonds mix more to your liking.

Whatever mix you decide on, you can get an idea of how it might perform by plugging it into the Asset Allocator tool on T. Rowe's site.

One final note: your retirement investment strategy isn't something you create in a vacuum. It should be part of an overall plan that includes a look at how much you're saving, how much income you'll need in retirement and what other resources you'll have to draw on once you retire.

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Need help with a financial dilemma? In an upcoming issue, Money magazine will be answering reader questions. Email money_letters@moneymail.com. To top of page

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