So this post will be a bit of a departure from my normal data ramblings and musings, but hopefully it’ll show that analytical minds will analyze just about anything. I know mine does!
As any of my current or previous coworkers will tell you, I am a huge advocate of investing in your 401(k) for a multitude of reasons (none of which I’ll go into here – at least not today). However, as this is the largest non-home asset many people will have, it’s important to understand how to act both aggressively and defensively in order to maximize your return and/or to minimize your exposure to market turns. Which you choose will largely depend on your opinions on the market, but for today, I’m going to concentrate on how to protect yourself if you fear a market crash.
If you google defensive investing, any number of sites will give you strategies on what to do, and some will even give you specific investments to make. Unfortunately, 401(k) investment options are often very limited, so there is only so much advice that you can take – unless, of course, you have planned for such a scenario. Here are several basic strategies, as taken from Forbes magazine.
- Accumulate Cash – In terms of a 401(k), there are generally few options available. Two things you can look for are bond funds and money market funds. Both generally offer low yields, but as a compensation, unless you are choosing a junk bond fund, they also generally don’t lose value, either.
- High Dividend Stocks – Hands down one of my favorites, but very dependent on the 401(k) options. When I worked for an energy company, this is where most of my 401(k) was invested. If the stock price rose, so did my 401(k). If the stock price dipped, my reinvested dividends bought more shares, increasing my profits on a market rebound.
- Investing in Value Stocks – This can be tough with limited 401(k) options, but in a nutshell, if you see a sector or fund that you think is undervalued, pounce on it. In the early 2000’s, I was fortunate enough to ride the wave of the rise of International Equities in my 401(k), which provided a nice boost in the post dot-com bubble economy. This is definitely a hit-or-miss option, depending on your 401(k) options.
- Invest in Sectors Likely to Outperform the Market – As with the above, this can be tough with the limited investments available to you. However, if you believe a fund or sector is poised to breakout – even through a potential recession, then invest in it! With that in mind, if you believe in it, why isn’t your money already there?
- Real Estate Investment Trusts – Not often available in your average 401(k) portfolio, REITs are a great way to diversify your portfolio through the addition of real estate. As an added bonus, they are often high dividend investments, which offer cash to reinvest into a falling market.
Of course, if you look through your 401(k) documents, there’s likely another option – albeit an unpopular one with financial gurus. You could take a loan on your 401(k). Most plans allow for this, and federal law gives you the right to take up to half of your 401(k) balance, or $50,000 – whichever is the lesser value. To be clear, there are valid concerns with taking a 401(k) loan, as it can negatively impact the end result of your retirement dollars. To be frank, they have a point. However, in this case, you’re not looking to withdraw the money to spend it. You’re withdrawing it in order to protect it.
Let’s look at the math. If you have a balance of greater than $100k, you could take a max withdrawal of $50k. As of today, there are a number of banks offering “high yield” savings accounts for investors who keep a large minimum balance. As of September, 2019, these can vary from between 2-2.5%. Let’s assume the lesser end of this range. Here’s the algebra behind determining your annual return, and what each variable represents:
I = Interest Earned
L = Loan Amount
C = Cash reserves on Loan Amount (This is used to cover any shortfalls needed in order to repay the loan while not reducing your normal annual 401(k) contribution. You can just use loan amount / years of loan to simplify the math.)
K = 401(k) Balance at the beginning of the loan
R = Rate of return on 401(k) investments
(1+I)*(L-C) + C+ K*(1+R)
So, now that we have the formula, let’s plug in some numbers.
(1+.02)*(50,000-10,000) + 10,000 + 50,000*(1+.10) = $105,800 = 5.8% ROI
Assuming the same return with no loan, your ending balance is $110,000 = 10% ROI However, when doing the math, we neglected the loan repayments of approximately $900 being repaid into the account and drawing the investment ROI. With the ups and downs of the market, we can’t really calculate it for certain, but if the ROI was relatively consistent, then you can dollar cost average it to approximately a 5% ROI. This means the formula is really more like this:
(1+I)*(L-C) + (C*(1+(R/2))) + K*(1+R)
(1+.02)*(50,000-10,000) + (10,000*(1 + (.10/2))) + 50,000*(1+.10) = $106,300 = 6.3% ROI
In this case, by taking your loan out during a Bull Market and putting the cash in savings, you’ve effectively reduced your retirement growth by a little more than a third for the year. However, you’re still making a decent overall return on the investment, and most importantly, you’ve hedged your bets a bit. What happens if the market goes down by 10%? Ignoring that most crashes happen quickly over the span of a few days or weeks at most, then turn into long recovery periods, let’s look at the math.
(1+.02)*(50,000-10,000) + (10,000*(1 + (-.10/2))) + 50,000*(1+-.10) = $95,300 = 4.7% Loss
It’s important to note that because you were able to preserve your capital withdrawn via the loan, while still making a small amount of money on it, your negative return has been reduced by more than 50%. So, in exchange for reducing your gains by 1/3, you have also reduced your losses by more than half – and that’s not even the best part!
Remember in the beginning, where we lamented the variety of options within a 401(k) plan? In a market crash, stocks are effectively on sale. Want to invest in a dividend stock? A pre-crash stock worth $100 with an annual dividend of $4 will purchase one share per hundred shares owned every quarter. However, that same dividend purchases 1.1 share for every hundred shares owned each quarter after a crash of 10%. Further, you’ve effectively managed to sell high and buy low, as your purchase of the shares will be at a nice 10% discount – giving you 11% more shares to begin with (100%/(100-10%)) = 11.11%. When the stock rebounds, you will profit handsomely. Use this profit to pay back your loan early, and fully fund your Roth IRA, HSA, FSA, 529 plan, or Coverdell account.