What Happens to Your 401(k) if the Stock Market Crashes?

Despite a few short-lived rough patches, the stock market has been surging over the past year. The S&P 500 has earned total returns of nearly 26% over the last 12 months, as of this writing, and it's soared by nearly 17% since late March alone.

But there is no shortage of concerns among Americans. Inflation just hit a three-year high, and many consumers are feeling the pinch at the pump, with the national average gas price reaching $4.51 per gallon, according to AAA.

To be clear, this doesn't mean a stock market crash or recession is inevitable. But it can be wise to at least understand how a market downturn might affect your retirement savings. Here's what could happen to your 401(k) if stocks take a turn for the worse.

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Will your 401(k) crash during a recession?

One of the more confusing aspects of the stock market is the difference between temporary and permanent losses. Your investment account may lose value during a downturn, and while that's daunting, it's also normal. It's also not quite the same thing as losing money in the stock market.

When stock prices drop, your investments are worth less. But when the market bounces back and prices jump again, your investments should regain that lost value. As long as you keep your money in the market, you won't technically lose any money.

Selling your investments is where it gets trickier. If the market drops and you withdraw your money from your 401(k), you could end up selling your investments for less than you paid for them. In this case, you might actually lose more than just value.

Say, for example, you invest $1,000 in an index fund through your 401(k), but then the market crashes and your account balance drops to $600. If you sell at that point, you'll have locked in a $400 loss. But if you hold on to your index fund until it regains its lost value, your account balance should return to $1,000 without your losing anything.

Even the most severe market downturns are temporary, with the average S&P 500 bear market lasting just nine months, historically. Rather than pulling your money out of the market at the first sign of trouble, it's often safer to simply ride out the storm and wait for your investments to eventually recover.

What should you do with your 401(k) right now?

It can be tough to manage your savings if you're nearing retirement or already retired, because you'll probably need to withdraw at least some money from your 401(k). If the market dips, you might have no choice but to sell at lower prices and accept some degree of loss.

However, with proper asset allocation, you can help limit how much value your 401(k) loses in the first place.

Asset allocation refers to how your investments are split up within your account -- typically between stocks and bonds. While stocks can earn higher returns over time, they're also more volatile. Bonds are generally safer, but investing too heavily in them can severely limit your investment growth.

As you near retirement, your portfolio should gradually shift toward more conservative investments. This way, if the market crashes right before retirement, you won't be hit quite as hard. You might still have to sell your investments for less than you paid for them, but the losses may be much less severe than if you were investing solely in stocks.

Proper asset allocation will depend on your personal preferences and risk tolerance. A general guideline, though, is to subtract your age from 110, and the result is the percentage to allocate to stocks. If you're 65 years old, for instance, you might want to allocate 45% of your portfolio to stocks and 55% to bonds.

It's impossible to say what the market might do in the coming months, but it never hurts to prepare for the worst just in case. Proper asset allocation is key to protecting your savings and securing your financial future.

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