Understand the market and how it can impact your retirement plan

The stock market has shown recently that it can be fickle, unpredictable and – when it comes to retirement plan portfolios – pretty cruel.

Since November 2007, investors have lost some $2 trillion from their 401ks and IRAs, according to the Center for Retirement Research.

It’s important, however, to maintain perspective, not panic and weigh carefully trading or switching investment options in hopes of a better return. After all:

• Market ups and downs, particularly over the short term, are a normal part of investing. Historically, the American economy has proven to be pretty resilient.
• Funding your retirement is a long-term goal. Investing for the short term may not give your investments time to potentially grow.
• When you sell an investment, you take the chance of missing a major market upswing – and it can happen very quickly.
• Continuing to invest regularly over a period of time may actually help you overcome uncertainties in the market. This concept – known as dollar cost averaging – does not, however, assure a profit, nor does it guarantee against loss in a declining market.
• There may be stiff penalties for cashing out of your retirement plan early. With a 401k, for example, you’ll owe income taxes on the amount withdrawn and, if you’re younger than 59½, maybe a 10% penalty. Plus, your employer may withhold 20% of your account value to prepay part of your taxes.

Why the market does what it does

First, know that every asset class – stocks, bonds, cash and real estate – can be affected by cyclical patterns.

However, different types of investments tend to move in opposite directions as a result of changes in the market. History shows that when stocks increase in value, bond prices typically decline – and vice versa.

Second, what makes markets go up and down – market volatility – is often affected by economic and political conditions.

For instance:

• Stock and real estate markets typically do well in a growing economy. Cuts in taxes and interest rates, high employment, political stability and increased corporate profits also can mean rising stock values.
• Bond markets historically do well during times of political uncertainty. Moderate inflation, international conflicts, a volatile stock market and tight money supply often are a boon to bond markets.

Three ways markets can react

• A correction
  A sudden drop of 10% in the major market indexes – like the Dow Jones Industrial Average* or the Standard & Poor’s 500^® Index.**
  
  After a correction, stock prices tend to more realistically reflect a company’s growth and earnings potential.
  
  Investors may not be happy about the decline in stock values, but they should know that the market sometimes rebounds quickly after a correction.
   
• A crash
  What happens if the market keeps dropping – say, 20% or more in a short period, accompanied by widespread selling?
  
  That’s a market crash. We’ve had two major crashes in the 20th century: A 23% fall over two days in 1929, and a 22.6% one-day fall in 1987.***
   
• A bubble
  That’s when overly optimistic investors drive stock prices to unsustainable levels.
  
  It last happened in the stock market in the late 1990s: The bubble burst, investors began to sell and stock values plummeted.
  
  Although it may take a while, post-bubble stock prices often deflate – giving investors the opportunity to buy at bargain prices.

Another kind of cycle – cyclical stocks

Investments in certain economic sectors typically experience predictable ups and downs because their performance is closely tied to what’s happening in the economy.

So-called cyclical stocks do well in a strong economy, but may suffer during an economic downturn. Examples: Airlines, housing and automobile manufacturing.

Conversely, stocks in pharmaceuticals and utilities are more apt to weather an economic downturn because their products and services generally aren’t tied to the economy.

Want additional information?

Learn more about these and other financial issues on the Investments Resource Center. Or talk with your employer, retirement plan administrator or investment professional.

* The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.
** Standard & Poor’s 500^® (S&P 500) Index is an unmanaged, market capitalization-weighted index of 500 widely held stocks of large U.S. companies. It gives a broad look at how the stock prices of those companies have performed.
*** FactSet Research Systems, Inc.

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