How To Protect Your Retirement Fund from a Stock Market Crash
The stock market is volatile, yet most of us store our retirement savings in its unpredictable clutches. So what do you do when the stock market crashes before the day you chose as your retirement?
Contrary to media reports, people in that position rarely “lose everything,” unless they invested in penny stocks or other clearly risky assets (as opposed to the safer mutual funds and ETFs). The stock market is cyclical, and historically it’s had a major crash every decade or so. It’s impossible to predict the exact timing of each crash, so whenever one comes along, it creates an avalanche of fear and angst.
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Normally, the best strategy to handle a crash is simply to ride it out. If anything, see if you can buy more when prices are low. But when you’re about to retire and your nest egg is cut in half, that prospect is a lot scarier.
Don’t Change Course
In reality, your position when you’re close to retirement is not much different from someone younger, who has the luxury of riding out the crash.
If this sounds surprising, it’s because of a relatively common, but unspoken assumption that the value of your nest egg stops growing the day you retire. Without articulating it, many people think if the stock market crashes, say, six months before they retire, they are doomed, because they don’t have the luxury their younger compatriots have of riding out the crash, letting their investments recover.
That assumption is false, because it overlooks two key facts:
- If you’re like the majority of people, you will probably live another twenty years or more after you retire, leaving you more than enough time to ride out not one, but multiple stock market crashes.
- What matters most to you in retirement is not the lump sum value of your investment portfolio, but the income stream it offers you.
So, while it may be even harder to ride out that crash, try not to let it worry you too much.
Focus On Income-Friendly Investments
As you approach retirement day, it’s important to begin thinking less about the lump sum value of your nest egg, but how you will live off it.
To start, formulate your monthly budget. Our society today is built around a monthly financial cycle. Your home and car payments are monthly, as are your utility, phone and cable bills. If you claim Social Security, it comes in monthly payments. Therefore, it’s important for you to figure out how your retirement fund will cover those monthly bills.
So, convert your investments to things that produce a monthly or quarterly income stream. When the stock market crashes, those investments continue to yield their monthly or quarterly income. Here are a few alternatives.
Bonds
The older you get, the more you should shift your investments from stocks to bonds. That way, by the time you retire, a good portion of your nest egg will be in less volatile assets. Most people invest in bonds through mutual funds or ETFs, because bonds are difficult to invest in “straight,” i.e. physically buying actual bonds. (Single bonds run around $1,000 a piece and transactions costs are high. If you want to buy a diversified portfolio of bonds, you’re talking more money than mere mortals have to invest.)
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Be aware, though, that when interest rates rise, the value of bond funds will fall. Granted, it’s not as dramatic as the drop in the stock market, but that drop also has freak-out potential—so keep calm and carry on. If you focus on the income you get from bond funds, and pay no attention to their value, stock market crashes won’t matter to you nearly as much.
Rental Property
Buying the house or condo next door and renting it out is often a good investment. Rent comes in every month, whether the market crashes or not, and most lease contracts have escalation clauses built in.
However, there is the risk that a recession—which invariably follows a stock market crash—might cause tenants to be late with their rent, or to miss payments altogether. Furthermore, to buy a rental property, you need a significant chunk of change, usually $50,000 or more. Taking on debt as part of a rental property investment increases your risk, because you’ll be on the hook for the payments when the tenants suffer from the downturn and can’t pay their rent on time, or, worse, they may not be able to pay rent at all.
Most of the time, however, rental income is largely immune to stock market shocks, and they can be well worth the work you put in.
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Annuities
Annuities are products sold by financial services companies. You typically buy one with a lump sum, and in exchange it pays you a regular monthly payment. Essentially, it pays you back your investment and the interest/yield over so many months. Those payments are largely unaffected by the state of the economy or the stock market.. Annuities are popular with the set of people who say, “I don’t want to mess with investing, I’d rather have a paid professional take care of that for me.”
The key word in that sentence is “paid,” because those paid professionals don’t come cheap. They often get sold like timeshares, by highly commissioned agents. That expense gets paid up front and in the end the question is whether the additional returns the professional investment managers generate compensate for the higher expenses. They often don’t. So, for someone who is very risk-averse and/or doesn’t want to spend any time at all on investing at all, annuities remain a viable alternative, much like getting someone to wash your car or manage your lawn. It’s expensive, but beats doing nothing.
Dividend Stocks
If you don’t want to withdraw a lump sum out of your investment portfolio for property or annuities, and you don’t want to risk rising interest rates from sapping your bond funds, there is another type of investment you ought to consider: dividend stocks. As you approach retirement, you can swap out the mutual funds, ETFs and stocks you own and buy dividend stocks instead.
There are two types of dividend-paying stock for you to consider:
Dividend Aristocrats: This an elite group of stocks, about 50 or so, which have paid a growing dividend for 25 years or more. It’s important to note two things about this class of stock (about which you can read more here):
- Those dividends were paid consistently through at least two stock market crashes and recessions.
- Not only did they keep paying those dividends for so many years, to qualify for this list, they had to increase their dividend every single year.
Dividend aristocrat stocks give you choice about how to invest in them: you can buy one or more of the stocks and create your own portfolio, or you can buy an ETF or index fund which offers more diversification in exchange for a small fee.
When the stock market crashes, the prices of these stocks go down, too. But if you’re holding them for the dividends, that doesn’t concern you, because these are the bluest of blue chip stocks and those prices will recover with the market.
Preferred Stock: The second special class of dividend paying stocks is preferred stock. Some pay a higher rate than other dividend stocks, but the dividend never grows. Others have variable dividend rates. Preferred stocks are almost like bonds, in that they pay a quarterly dividend. However, they are much easier to buy—they trade just like regular stocks, so you can buy as few or as many as you want. As with dividend aristocrat stocks, you can invest in preferred stocks through ETFs or mutual funds.
As you approach retirement, you need to reconstitute your retirement funds so they provide you with the monthly or quarterly income you need to live the life you worked so hard for.
If you’re close to retirement, the time to make those changes is now. Once you have a portfolio of the types of investments outlined above, the inevitable stock market crashes which will be part of the rest of your life will leave you largely unaffected.
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How To Protect Your Retirement Fund from a Stock Market Crash
