The U.S. economy has proven incredibly resilient amidst President Trump’s tariffs, numerous geopolitical conflicts, and historically elevated valuations. Still, there’s no doubt that the country will eventually find itself in another recession. And, by reviewing some basic rules for managing your 401(k) during a recession, you can avoid making costly mistakes with your retirement savings.
1. Don't Make Fear-based Trades
Research shows that less than ten days per year account for almost all the market’s gains or losses. For instance, in 2020, a single trading day accounted for the entire annual gain of the Dow Jones Industrial Average! If you panic and sell after a significant market drop, the odds are that you’ll miss the subsequent rebound, resulting in all the losses and none of the gains.
The best way to avoid making fear-based trades is to ensure that your risk tolerance levels are appropriate and stick to your plan. While watching your portfolio drop can feel like inaction, try reframing the feeling to that of patience and discipline. Staying the course can help you capture more of the gains, less of the taxes (you may owe taxes when you sell!), and increase your risk-adjusted returns.
2. Build Up Your Emergency Fund
Recessions can trigger job losses as companies cut costs and slow their hiring practices to better manage cash flows. If this happens when the stock market is already down, you might feel pressure to take early 401(k) withdrawals to cover your expenses. Unfortunately, these withdrawals come with potential penalties and taxes on top of selling at already depressed prices.
You can avoid the need to take costly withdrawals by ensuring you have a sufficient emergency fund built up. Generally, it’s a good idea to have three to six months of living expenses, including mortgage and groceries, in a high-yield savings or money market account. If you don’t have these funds in place, consider reducing your 401(k) contributions to build up your reserves.
3. Rebalance Your Portfolio
Vanguard researchers found that the decision of how to allocate assets (stocks vs. bonds vs. cash) explains roughly 90% of a diversified portfolio’s performance over time. By contrast, less than 10% of a portfolio’s performance was driven by security selection and market timing. As a result, it pays to ensure that your asset allocations are on track over time to optimize your returns.
Unless you use target-date funds or work with an advisor, it’s easy to forget to rebalance your portfolio on a regular schedule. For example, a boom in tech stocks can leave your portfolio heavily exposed to the tech sector — a sector that might be heavily hit during a recession. By rebalancing at least once a year, you can ensure that it is diversified and well-positioned to navigate a recession.
4. Harvest Your Tax Losses
Rebalancing your portfolio often involves selling winners to even out your portfolio, but selling losing positions can also be beneficial during a recession. Research shows that tax-loss harvesting can add 0.3% to 1% per year to your portfolio returns without taking on any additional risk. And when a recession hits, there are more opportunities to harvest losses and boost your alpha.
Under current rules, you can use harvested tax losses to offset any capital gains and up to $3,000 per year in ordinary income. And if you have unused tax losses, you can carry them forward to offset future capital gains. Recessions can increase the benefits of tax loss harvesting from less than 1% on average to 2% to 5%, according to some estimates.
5. Consider Buying the Dip
Baron Rothschild once said, “Buy when there’s blood in the streets, even if the blood is your own.” He made a fortune buying during the panic following the Battle of Waterloo against Napoleon. Billionaire investor Warren Buffett had similar thoughts, noting, “you pay a very high price in the stock market for a cheery consensus,” implying that the good times are rarely a good time to buy.
During a recession, equity prices tend to move sharply lower to account for a revised economic outlook. Some of these price movements are justified as the discounted value of future cash flows drops, but almost always, the reaction moves too far in the bearish direction, leading to steep discounts that investors can take advantage of by purchasing when others are selling.
The Bottom Line
Recessions are a stressful time even for seasoned investment professionals. By following a well-thought-out plan, you can avoid many of the pitfalls of recession investing and even improve your long-term risk-adjusted returns. The key is planning ahead of time and sticking to your plan rather than being reactive to market sentiment and emotion.
