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Stock market rallies are best time to prep your 401(k) for next downturn

401(k) tip: It's time to plan for next market drop

Is your 401(k) built to last when the next stock market downturn hits?

Now — when times are good on Wall Street — might be the right time to find out.

A video board display's the day's closing number of the Dow Jones industrial average at the New York Stock Exchange on Oct. 18, 2017. The Dow surged to a record, easily topping 23,000.

U.S. stocks are up about 15% this year and hovering near record highs. Investment pros see few immediate threats on the horizon. Economies around the globe are strengthening. Corporate profits are solid. The market is calm. Fear is low. And panic is absent.

As a result, investors' emotions are in check. And that is the perfect psychological state to be in when setting up a plan for the next time stocks are in freefall .

“A plan is an antidote to panic,” says Anthony Ogorek, CEO of Buffalo-based Ogorek Wealth Management.

The broad Standard & Poor's 500 stock index hasn't suffered a 5% drop since June 2016, or 481 days ago — the longest rally without a pullback in more than 21 years, according to Bespoke Investment Group. It's been 351 days since the market fell even 3%. And the market has gone 20 months without a 10% drop, or correction.

The market could fall 3% to 5% at any time

The market, though, could suffer a fall of 3% to 5% at any time, says Ryan Detrick, senior market strategist at LPL Financial. And after a long period of market calm, even a small drop may feel "a lot worse" and lead to investor angst.

"When the inevitable stock correction or market volatility hits, that is when emotions are high and when investors make mistakes," says Detrick.

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Just like a coach draws up a game plan before a team takes the field, investors should map out a plan of action ahead of the next market downturn, Wall Street pros say.

“To me, there is a big danger of people being too aggressively invested – period,” says Susan Kaplan, president of Kaplan Financial Services, a wealth planning firm in Newtown, Mass.

Here are some money moves to put in motion now to help you ride out the eventual market drop:  

Stress test your portfolio

When stocks are at record highs, most investors get a false sense of their true risk tolerance, or ability to emotionally and financially deal with losses. The best way for investors to find out how big a market drop they handle is to envision how they would feel if the market tanked, Kaplan says.

Laying out worst-case scenarios, she says, is a good way to do that.

“When I tell clients who want to go all-in, ‘You could lose one-third of your portfolio,’ that normally stops them right there,” Kaplan says.

And putting a dollar amount on their potential losses “gets their attention” even more, she adds. A 20% drop in the Dow, for example, would result in a paper loss of $30,000 for someone that had $150,000 invested in the Dow in their retirement account.

Your investment mix may be riskier than you think

The bull market in stocks has been going on nearly nine years and the Dow is up another 17.8% this year. Those price gains mean investors might now have too big a helping of stocks.

The question investors need to ask is, “What was the asset allocation supposed to be and what is it now?” says Brad Bernstein, senior VP, Wealth Management at UBS Financial in Philadelphia.

An investor, for example, that built a portfolio with a mix of 70% stocks and 30% bonds might now have 80% of their cash riding on stocks. That means the portfolio has gotten more aggressive and riskier than originally constructed.

To get things back on track, an investor should sell enough stocks and invest the proceeds in bonds to get back to the initial 70/30 asset pie, advises Bernstein, referring to a risk-management strategy known as “portfolio rebalancing.”

Bernstein recommends rebalancing a portfolio each year, or after large market moves. “It removes the emotion” from your trading moves, he adds.

Balance need and greed 

If you have money in the stock market earmarked for use in the next 12 to 18 months to say, buy a car or to be used for a home down payment, now is not the time to be pushing for every penny of profit. 

"That money should be in cash," says Ogorek. "If you know you will have to write a check soon, don't try to be cute and eke out a little more money out of the stock market. You don't want those dollars to be subject to market fluctuations," or falling prices.

Young investors that are saving for retirement 20 to 30 years from now should not worry about what the market is doing now or tomorrow. There is plenty of time to recoup any short-term losses, and any pullback that does occur along the way will allow them to buy more shares at cheaper prices.

"For young people there is nothing to think about," says Kaplan. "Put it in the market. Close the door. And walk away."



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