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Meet a 401(k) Dufus
By JLP | June 4, 2007
Okay, maybe “dufus” is a little harsh but read this letter/question that was submitted to Money’s Walter Updegrave:
In December, 2005 I spread the $200,000 in my 401(k) account across funds that had gained 20 percent or more a year over the previous three years. Those funds gained about 30 percent in 2006. I’m following the same strategy this year and so far I’m up about 30 percent. I should add, though, that following this strategy has put about 65 percent of my money in foreign stock funds, and I’ve also ended up with several sector funds. I’ve got another 10 to 15 years before I retire. Am I being brilliant or blissfully ignorant of risk? – Forrest, Madison, Alabama
As always, Walter’s response is both thoughtful and wise.
I think the best strategy is to concentrate on asset allocation and forget about performance unless you have to make a choice between two funds that are similar and even then I would approach that decision with caution. A typical 401(k) should have the following asset classes:
Large Cap Stocks
MidCap Stocks
Small Cap Stocks
International Stocks
Real Estate Investment Trust (REIT)
Bonds
The allocations to these funds should be based on the person’s age and number of years until retirement. I know lots of people who will disagree with me, but at my age (37) I have chosen not to invest in bonds. Based on the asset classes above, I would put 20% into every asset class except bonds. I would then leave it alone, only adjusting the allocation every one or two years just to bring it back into balance.
What’s scary about the guy’s strategy in the letter above is that he is playing with his RETIREMENT money, which is money he can’t afford to lose. If he wants to play, he should set up a small brokerage account and have some fun that way.
Topics: 401(k), Investing, Retirement Planning | 8 Comments »
June 4th, 2007 at 3:54 pm
I agree 100%, playing the return game with retirement money is a disaster waiting to happen. With 10 years until retirement, he should be slowing down and making his retirement funds more secure. Right now saving his income and investing it should where all his energies are, not bouncing around his 401k.
Personally, I don’t know enough about economics to manage my funds in such a way, so I leave it to the professionals.
June 4th, 2007 at 4:42 pm
I find it interesting that REITs have become their own asset class in recent years, much like Technology did in 90s. REITs, like Technology, already have a decent weighting in large cap indices the S&P 500 and the Russell 1000 as well as mid and small caps. When you add more you are just overweighting a specific sub-sector of the market. Why REITs and not Retail Stores, Insurance Companies, or Biotech? I suspect recent performance has earned it the temporary designation of its own asset class.
June 4th, 2007 at 5:56 pm
I think the reason REITs are becoming their own asset class is that (arguably) real estate and the stock market aren’t tightly coupled, and so (perhaps more arguably) an REIT that is traded like a stock/ETF would also be less coupled to the performance of the stock market as a whole.
REITs are being touted as a form of real estate ownership. I don’t really understand myself the extent to which an REIT is just another stock/ETF as opposed to being a form of real estate ownership. Seems grey to me.
On another note: sometimes I hear of people doing things like day trading inside their 401(k) or IRA, which also scares the tar out of me.
DB
June 4th, 2007 at 6:04 pm
Ok I definitely see the point here about diversification and I agree conceptually that this the best advice possible for someone who has definitely backed themselves into a really sad corner. Given his limited investment horizon there’s no other option.
Let me play a little devil’s advocate here and say that I’m unbalanced towards foreign funds myself and I think it’s been a valid strategy for me.
First off, let me give you some detail about my financial situation.
1. I’m 42 and making 46k a year right now, (not hot but better than national median household income). I’ve been with the same company for over 12 years now to some degree because of the great benefits here. More about that in a sec.
2. I have about 135k equity in my primary residence and 15 year fixed mortgage at 5.49% with 12 years to go on it.
3. The rest of my retirement assets are in a 401k, which is limited to the American Funds family. I’ve accumulated $147k in there to date most of that split pretty evenly between foreign/domestic. There’s very little small cap available in American funds and most of them aren’t so hot according to FundAlarm so I’m pretty heavily large cap.
4. I get very generous matching here (employer matches 100% up to 15% withholding). I’ve been working to withhold that 15% but for now I’ve had to limit that to 10% given my mortgage.
5. I can exchange shares between funds for free and they typically execute those within 24 hours.
Here’s the issue. Right now I am doing exactly what the article is warning against. The bulk of my contributions go into the ICA fund initially. ICA is pretty conservative and the returns reflect this. I had the bulk of my money there during the dot.com crash (thank god) but have been moving out of it every quarter in 5-10k batches into more aggressive funds over the last 3 years or so.
Most of these exchanges went into foreign funds (EuroPacific and New World) over the last 3 years and I’ve obviously been pleased with the performance during that time. I’ve reached nearly 65% foreign to domestic currently. That’s as far as I plan to unbalance things.
Given my long investment horizon and pretty high risk tolerance (i didn’t blink at all during the correction in late February), and given that I can respond pretty quickly to market changes I monitor, why shouldn’t I continue to pursue this strategy?
Is there really a chance that I’m going to be wiped out by a sudden correction in the foreign markets? Don’t mutual funds, particularly huge one like American Funds limit your volatility and give you time to respond to market turn-arounds? After all I can exchange to something less volatile within a day or two.
Am I gambling to some extent by overbalancing to foreign funds? Sure. It’s been working pretty well so far. I’ll be scaling back the other way over the next 6 months most likely, but for now that’s my allocation. Let the scolding begin…
June 4th, 2007 at 7:02 pm
I think his strategy has just been lucky more than anything else. However, I’m not sure he’s in immediate danger if he has 65% of his money internationally invested. It seems like a fine enough percentage to me. I know it’s more than most people suggest, but hey, the US does not make up 80% of the world, putting 80% of your money there doesn’t to make sense. If there’s a downturn in the US economy you’d lose a ton of your retirement and possibly your job.
The problem is likely with the sector funds. It would have led you to invest in XLK or QQQ in 2000 and have of your money would have been gone very quickly.
June 5th, 2007 at 8:48 am
db wrote: REITs are being touted as a form of real estate ownership. I don’t really understand myself the extent to which an REIT is just another stock/ETF as opposed to being a form of real estate ownership. Seems grey to me.
I agree. I own an REIT fund, but I don’t think it’s like owning actual real estate since it’s property, property management companies and financing firms that deal mostly in commercial real estate. However, it’s all of the profits and none of the headaches of being a landlord.
As long as commercial properties are doing well, I’m doing well. The REIT fund allows me to be diversified in several metropolitan markets for real estate in a way that I couldn’t do as an individual investor, but it’s not really real estate. It’s a sector specific fund. Those companies could be run into the ground like any other company.
As to the main part of the post, I thought Mr. Updegrave’s inquirer was kind of crazy. Rebalancing to chase returns is nutty. However, I don’t think a person should not chase any returns. I have a good feeling that international markets are going to do well in the next 3 years, so I’m contemplating halting my contributions to one fund to free up assets for an international fund. I think for my time horizon on retirement (30+ years), I can afford to chase some returns early, especially if we’re talking about spectacular returns (20+%) vs more reasonable returns (8-12%). Sure, I risk losing, but I risk losing in ALL mutual funds and investment vehicles, short of US Treasuries. (ick)
FWIW, my 401k account has two really lousy small cap funds (and no mid-cap), but my private IRA has better ones of both, so there is rebalancing one account vs rebalancing my entire portfolio, and chasing returns in the right place.
June 5th, 2007 at 10:47 am
I really don’t like the concept of a basket of funds. Funds are already supposed to be diversified, so forget about further diversifying by selecting a bunch of funds. The only caveat to that is perhaps international exposure. Basically, just get your cheap index funds for your “invest and forget” portion.
If he wants to actively try a trading system that he thinks works then why not let him? I personally wouldn’t try it because I don’t believe in mutual funds except indexes, but he’s up 30% twice in two years (so almost 70%) which is way better than me. He would have to very unlucky to now lose that much.
June 5th, 2007 at 3:13 pm
I would recommend diversifying into as many sub-categories as possible and preferrably with low correlation, and don’t forget to rebalance (which is basically the opposite of what the writer is doing, and his strategy will hurt him in the long run). I have all these categories plus emerging markets, energy, metals, small, medium, and large value, and international small, medium, and large growth and value. And I am always looking for new ideas. Some books I read will split international into europe, pacific rim, and Britain. Pacific rim can be split into Japan and non-Japan, etc. Canada is available as a specific category. Etc, etc. The idea is that everything doesn’t appreciate at the same rate, and you don’t know what will go up when, so diversify and rebalance.