*** Are the Markets & My 401(k) Heading for Another Freefall?

Dear Bill: I’m 60 years old, divorced, and was forced into early retirement two weeks ago. My 401(k) is still down 25% from its all-time high and I’m real nervous. Now that I don’t have a paycheck and since I won’t become eligible for Social Security for two more years, I have to live on this! How should my account be allocated? What’s an appropriate allocation for someone in my situation? I was also wondering what you think about the possibility of another market freefall? Christine, R.I.

Answer: Christine, let me start with your last question first. Despite the recent market rally and leading economic indicators looking more positive, I have absolutely no doubt in my mind that at some point again in the future we will have another period where the markets experience a significant decline. The problem is no one, and I mean no one, ever knows when the next freefall will happen and what will trigger it. Personally and professionally, I have no clue whether the next 20% market move will be up or down but I remain a focused and disciplined advisor because the next 100% move has always been up. In short, you’ve got to have some money in the market in order to have the potential to achieve a higher rate of return to keep pace with inflation over your lifetime.

Stock prices are totally random and unpredictable but one way you can mitigate this risk is to broadly diversify your investments through asset allocation. Asset allocation refers to how you divvy up your money among the three major asset classes which are stocks, bonds, and cash. While it (asset allocation) can minimize the risk to your investment portfolio it cannot prevent declines.

For my private clients (usually women and couples between ages 50-65), depending on their goals, debts, health and appetite for risk, I usually will suggest a broadly diversified investment portfolio of low cost index funds, enhanced index funds or ETFs, with somewhere between 40-60% in stocks. Your portfolio should include both domestic and foreign investments, on both the stock and bond side, with perhaps 10-15 holdings overall.

One issue I see that could prevent you from broadly diversifying your 401(k) is the limited fund choices you have available. A better alternative may be to consider rolling over your 401(k) to an IRA. Your money will continue to grow tax deferred until you take it out, you control access to your savings, you have the potential to convert some or all of these assets to a Roth IRA in the future, but the big benefit is that you will have additional investment options and the ability to control your own costs.

Bill’s Bottom-line: Consider keeping two to five years worth of anticipated income needs in safe investments such as CDs, money markets, and t-bills at all times. This will prevent you from having to liquidate and spend your stock holdings when they could be down in value due to a temporary market decline. Catch a sneak peek of my free DVD, "The 10 Biggest Mistakes People Make When Retiring & How YOU can Avoid Them", at www.RetireinaWeekend.com.