How a recession affects your 401(k)
It's natural to worry about the impact of a recession on your portfolio. But just how much should you expect your 401(k) to fall? During the recession from 2007 through 2009, stock prices fell about 50% from their peak. So you would have seen your 401(k) take a major hit during that time.
The good news is that these kind of massive losses don’t accompany most recessions. In fact, during the past four recessions, the S&P 500 lost an average of 8.8%, according to data from CFRA Research.
The other good news is recessions don’t last as long as you may think. Over the past hundred years, the average recession lasted about 12.6 months. That average includes the Great Depression, which lasted for more than three and a half years before the economy started to inch upwards again.
When you look at the past 50 years, the average recession was less than 11 months. And the stock market eventually bounced back from every recession in history. Additionally, the stock market is generally forward-looking, meaning it usually starts recovering before the overall economy.
7 safest 401(k) investments during a recession
If you’re worried about a looming recession, you’re probably wondering which investments you should have in your 401(k) to mitigate your losses. 401(k) plans generally have fewer investment options than you might find in your individual retirement account (IRA) or taxable brokerage account. The good news is there are still plenty of excellent choices that can help you weather a recession.
1. Target-date funds
Target-date funds — also known as life-cycle funds — are some of the most popular 401(k) investments, and it’s easy to see why.
These managed funds hold a diversified mix of stocks, bonds, and other assets. Each target-date fund corresponds to a particular retirement year, and investors choose a fund based on when they plan to retire.
The fund manager adjusts the asset allocation of target-date funds over time. As the designated retirement date nears, the fund’s risk is reduced. The percentage of equities in the fund decreases while the percentage of bonds and other low-risk assets increases.
One of the major benefits of target-date funds is that they’re entirely hands-off for investors. You can simply put your money into them and know you’ll have a diversified portfolio appropriate for your time horizon.
More: Target date funds comparison: aren't they all the same?
2. Bond funds
Bond funds are mutual funds that hold a mix of bonds. These funds are attractive during a recession for a couple of reasons. First, while bonds tend to have lower returns over the long run, they also have lower risk. As a result, they can help mitigate some of your portfolio losses during a recession.
The other advantage of bond funds is the interest income they provide. Even if your portfolio value drops, you’ll still have an income stream from your bond funds.
More: What is the relationship between interest rates and the bond market?
3. Market index funds
Index funds are a type of mutual fund that tracks the performance of a certain financial benchmark — often an index like the S&P 500 or Dow Jones. These funds are passively managed. In other words, the fund manager doesn't buy and sell assets to beat the stock market, unlike actively managed mutual funds.
Index funds have plenty of advantages, including diversification and low fees. They’re also a great option during a recession. When you invest in an index fund, your portfolio recovers when the overall market does.** **But some individual stocks may not recover as quickly or at all.
For example, insurance company AIG's stock price collapsed during the 2008 recession and has never even come close to its regaining its 2007 highs.
4. Dividend stock funds
Dividend stocks in companies that pass along a portion of their profits to shareholders in the form of dividends. And many large companies make these dividend payments even during recessions. Companies that belong to the Dividend Aristocrats list, for example, have been raising dividends for at least 25 consecutive years.
The beauty of dividend stocks are that they can continue to produce income for you even while their share prices are down. And you can reinvest those dividend payments to help give your portfolio an extra boost when the market starts to bounce back.
More: How to invest in dividend stocks
5. Large-cap stock funds
Large-cap companies with a market capitalization of more than $10 billion tend to fare better during a recession than smaller companies. These companies are established and have a better financial foundation and, therefore, are better positioned to weather a recession.
Large-cap stock funds can be an excellent investment to have in your portfolio during a recession. That’s not to say your portfolio won’t lose value — because it probably will — but your losses may not be as extreme as if you had invested in primarily small-cap and mid-cap companies.
More: Large cap vs mid cap vs small cap stocks: balance your portfolio for the long haul
6. Defensive stock funds
Defensive stocks — also known as non-cyclical stocks or consumer staples — are companies which make products that people generally buy regardless of the economy. Some of the largest defensive companies include Procter & Gamble, Johnson & Johnson, Coca-Cola, and more.
Cyclical stocks and consumer discretionary stocks are the opposite of defensive stocks. These companies tend to fluctuate more with economic changes, primarily because they sell products that people are less likely to buy during a recession.
That’s not to say you should only have defensive stocks in your portfolio during a recession, but having a defensive stock fund among your other assets could help reduce your losses.
More: Best defensive investments to survive bear markets & high volatility
7. Blue-chip stock funds
There’s no official definition of blue-chip stocks, but the term generally refers to:
- Large, established companies that are financially stable
- Have a history of paying dividends (though this isn’t always the case)
- Have produced long-term sustained growth.
Blue-chips are either mid-cap or large-cap companies with a market capitalization of about $5 billion or more. While blue-chip stocks can still lose value during a recession, they're generally considered safer than other stocks.
More: Blue-chip stocks guide: should you buy in a during a market downturn?
Investing in your 401(k) during a recession
Investing during a recession can be scary. After all, no one wants to continue making contributions only to see them completely wiped away by portfolio losses. But the truth is that the best way to bounce back from a recession is to continue to invest in the middle of it.
If you make automatic contributions to your 401(k) each month, continue making them. In fact, some people even increase their contributions during a recession. After all, the stock market is essentially on sale, meaning you can buy more assets for the same amount of money.
Furthermore, it's even more important to avoid making withdrawals from your account.
If you sell your investments during a recession, you lock in your losses and get the worst possible price for them. In other words, you’re selling at the worst possible time.
Are you struggling to keep investing during a recession? For some people, an effective strategy is to stop checking your account balance for a while. You’ll be less tempted to stop investing — or worse, sell your investments.
If your 401(k) is with a previous employer, you may want to roll it over into an IRA before a recession. When you do, you’ll gain access to a wider variety of investment choices. You can also opt to roll your funds into an IRA with a robo-advisor that chooses investments on your behalf. This option could be ideal for someone likely to make emotional decisions during a recession.
401(k) asset allocation
Your asset allocation is the mix of investments in your portfolio. Generally speaking, your asset allocation should be based on your financial goals and time horizon. In the case of your 401(k), your time horizon is the amount of time before you expect to retire. Your asset allocation should also be based on your risk tolerance and capacity.
So should you adjust your asset allocation during a recession? Generally speaking, no. As long as you have a well-diversified portfolio that matches your risk tolerance and capacity, it’s best to make a few changes to your asset allocation due to a recession.
That’s not to say you should never change your asset allocation. As you get closer to retirement, your risk capacity decreases, and you should adjust your portfolio accordingly.
There are a few different rules of thumb experts recommend. In the past, some have recommended subtracting your age from 100 and investing that percent of your portfolio in stocks and the rest in bonds or other fixed-income securities. But many experts now recommend using a higher number, such as 110 or 120, to account for the longer lifespans we have today.
Can you invest in alternative assets inside a 401(k)?
Alternative assets include crypto, real estate, precious metals, wine, whiskey, and more. These alternatives tend to have low correlation to the stock market so they may outperform other investments during a recession.
Unfortunately, most 401(k) plans don't allow you to invest in alternative assets. In fact, most don't even allow you to invest in individual stocks and ETFs.
However, if you're self-employed, you may want to consider opening up a self-directed Solo 401(k). Money that's held inside self-directed retirement accounts can be invested in almost anything. Also, if you have a 401(k) from a previous employer, you can roll it into a self-directed IRA.
Just keep in mind that alternative assets are often riskier and more volatile than traditional investments like index funds. We recommend that investors limit their alternative investments exposure to 5% (or at most 10%) of their overall portfolios.
The bottom line
There’s no doubt that investing during a recession can be scary. But the good news is there are steps you can take and investments you can choose to help mitigate your losses. And while you’re likely to see your portfolio’s value take a hit during a recession, history tells that the decline is likely to be short-lived.