3 Ways to Protect Your Retirement Money From a Market Downturn

Last week we got a reminder of just how volatile the stock market can be, when the Dow Jones Industrial Average plunged more than 370 points, or 1.8%, in a single day on political turmoil in Washington. The stock market has already recovered from that setback. But at some point, though we don't know when, this aging bull market will give way to a bear that, if history is any guide, could send stock prices tumbling as much as 50%, or even more. Which is why you need to position your retirement portfolio not just so it can thrive if the market continues to climb, but so you'll be comfortable sticking with the investments you own even when the market reverses course.

With that goal in mind, here are three moves you should make now.

1. Check that your asset allocation is still in sync with your tolerance for risk.

Since bottoming out in the wake of the financial crisis a little more than eight years ago, stocks have gained nearly five times as much as bonds—an annualized 19% vs. 4%. That means that if you haven't been regularly rebalancing your retirement portfolio, you may be investing a lot more aggressively than you think. For example, someone who started with a 60% stocks-40% bonds portfolio in March 2009 would have upwards of 80% of assets in stocks and just 20% in bonds today, assuming no rebalancing and reinvestment of all gains.

To make sure you're not taking more risk than you intend—and thus leaving yourself open to larger losses than you can handle during market downturns—you need to confirm that the way you have your savings invested in your retirement accounts jibes with your appetite for risk.

Start by gauging how much risk you're comfortable with. You can do that by completing Vanguard's risk tolerance-asset allocation questionnaire, which you'll find in the Retirement Investing section of RealDealRetirement's Toolbox. Just answer 11 questions designed to determine among other things how long you expect to keep your savings invested and what size market setback you could tolerate before you panic and jettison stocks. The tool will suggest a mix of stocks and bonds that makes sense for your situation. Click on the "other allocations" link, and the tool will show you how the recommended portfolio as well as more aggressive and more conservative mixes have fared on average and in good and bad markets in the past.

Next, see how that suggested mix compares with how your savings are actually allocated today. If you have a relatively simple portfolio, you may be able to determine your current asset allocation by just toting up the value of all your stock funds and all your bond funds and then calculating the percentage each category represents of your portfolio overall. But if you've got your savings spread among more than just a few funds—or you own funds that invest in both stocks and bonds—you'll probably find it easier to plug the names or ticker symbols of your funds and the amount you have invested in each into Morningstar's Instant X-Ray tool. The tool will then calculate the value of stocks and bonds held by each fund and then combine those values to give you the stocks-bonds mix for your portfolio as a whole.

If your current asset mix isn't too out of whack, you may be able to just monitor it for now or bring it in line solely by using any new contributions you make to your accounts. But if your allocation has strayed far from where it should be, you may need to rebalance by selling shares of some funds. If that's the case, you'll probably want to limit selling as much as possible to tax-advantaged accounts to avoid triggering taxable gains.

2. Do a little pruning.

While getting your overall stocks-bonds mix right is the single most important step you can take to prepare for a possible market downturn, you should also consider weeding out any investments you may have acquired in recent years that, upon greater reflection, don't fit very well into your long-term investing strategy. For example, perhaps you became intrigued with the idea of capitalizing on the battle to fight the rising tide of obesity or cashing in on the growing demand for natural and organic foods by investing in the Obesity ETF or the Organics ETF.

The point is to streamline your portfolio so you don't wind up going into a market downturn with an unwieldy jumble of investments that will be difficult to monitor and manage effectively. While you're at it, you should also consider replacing any funds you own that have lofty expense ratios. Shelling out an extra half a percentage point a year or more in fees might not have seemed like such a big deal over a period where the market was generating double-digit gains. But with many pros forecasting returns in the low-to-mid single-digit range in the years ahead, focusing on low-cost index funds and ETFs like those on Money's list of the 50 best funds is your best shot at getting the returns you'll need to grow your retirement nest egg and ensure that it lasts a lifetime.

3. Write a letter to yourself.

Think of it as a note from the "you in the present," who's cool and collected while the market's still in bull mode, to the "you in the future," who'll likely be more frazzled and frightened when stocks are in (or appear to be headed for) a potentially devastating bear market. The idea is to get that future you to avoid reacting emotionally and doing something you'll later regret, such as bailing out of stocks in a panic.

This note doesn't have to be long and complicated. Mostly you want to remind your future self that trying to outguess the financial markets is futile and that you're better off in the long run sticking to the mix of stocks and bonds that you went to the trouble to create in the first place. In your note you might also propose a "cooling-off period" in the event of a major selloff, a requirement that no matter how strong the impulse to go to cash or invest in a supposed safe haven like gold may be, that you'll wait, say, seven to 10 days before acting on it. Such a waiting period may be enough time for you to reconsider and avoid making a rash move that you may later regret.

The bottom line: You should take the three steps I've outlined now, while the markets are still relatively calm. Because these moves won't be nearly as effective if you wait until a rout has begun.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.