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Wednesday, October 6, 2010

401k: Managing Emotions During a Financial Crisis

With our major financial institutions struggling with bad mortgage loans and stock markets tumbling over 40%, it’s clear that we are in the middle of a global financial crisis. Unfortunately, those investing in 401k during this time are feeling the impact of the crisis, especially the fallout of the stock market. As we watch our hard-earned savings in our 401k plan dwindle, it’s hard to know what action to take. Do we stop contributing? Do we pull the investments out of stock fund offering and move to bond funds or money market accounts? No matter what our decision, it’s important that we keep one thing initially in check, our emotions. Doing so may lead us to our best future investment decisions.

The stock market struggles in times of uncertainty and it’s easy to panic and let our emotions assume the driver’s seat for our financial wellness. However, as famous investor Benjamin Graham has said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” As history has demonstrated time and time again, recovery is not far behind. In the market crash of October 1987, the market recovered and rose 96% five years later. In the 1989 savings and loan crisis, the market recovered and rose 58% five years later. And more recently, after the attacks on 9/11 the market recovered and rose 40% five years later. We are two to three years in to the current financial crisis, so it’s important to begin looking ahead to our next steps.

Investing decisions boil down to two basic principles: time horizon and tolerance for risk. Time horizon is critical as funds that you need to use within the next three to five years should be invested conservatively. You don’t want to risk needed short-term funds in higher risk strategies. With 401k plans, the time horizon is fairly long (up to 30 years in some cases) so more risk can be taken to achieve a higher rate of return. Additionally, 401k plans are a great savings tool which reduce taxes and allow for tax-deferred growth inside the plan. Most companies no longer offer pension or retirement benefits so 401k will most likely be the primary tax deferred savings vehicle.

The other principle, tolerance for risk, is an equally important factor when making investment decisions. You want to avoid a volatile investment strategy that causes you to sell out when times are bad. For example, in 2002 many investors who had low risk tolerance sold out of stock investments after the market put in a bad year (S&P 500 down 22%). But by selling too soon, those investors missed a good recovery year in 2003 when the market was up almost 29%. An investor who is inclined to sell off at market lows (thereby missing the recovery) might be better off sticking to a lower risk bond fund they can hold for the long run.

Financial crises are inevitable, but over time they are overcome and the stock market marches ahead. The current global crisis is one of large scale and has deeply impacted our core financial institutions; it takes an especially strong stomach and level head to tolerate the declines. However, it would be a mistake for your long-term investing success to pull out of stock funds and sit on the sidelines in cash and miss the turnaround when the bargain hunters take over. A study by Lipper, a global leader in supplying mutual fund information, analytical tools, and commentary, found the average stock fund gained 11.6% from 1988 to 2007, while the average mutual fund investor gained only 4.5%. That’s almost a two-thirds sacrifice on return by making bad buy and sell decisions seemingly fueled by emotion.

Taking the long-term view and managing emotions during the market crisis can pay off in a significant financial gain. As successful investor and philanthropist Warren Buffet has said, “I will tell you how to become rich. Be fearful when others are greedy. Be greedy when others are fearful.”

We know it can be relatively difficult to manage your financial wellness in times of turmoil. Sometimes it’s best to seek advice from financial counsel whether from your personal financial planner or an outside firm. Financial Horizons offers personal financial planning and investment advisory services. The financial plan is a collaborative tool that identifies important goals. We work with individuals to assess those two important principles of time horizon and tolerance of risk to develop portfolio recommendations to help meet retirement or other financial goals.

This article contributed by Dave Shiell

Contact DAVE SHIELL at dave@fhllc.comThis e-mail address is being protected from spam bots, you need JavaScript enabled to view it , DENNIS BLODGETT at dennis@fhllc.comThis e-mail address is being protected from spam bots, you need JavaScript enabled to view it or JOY PUYEAR at Joy.Puyear@fhllc.comThis e-mail address is being protected from spam bots, you need JavaScript enabled to view it if you are in need of financial assistance or information regarding your 401k plan strategy.


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