This weekend I’m going to advocate corporate disloyalty, advise some folks to avoid investing in a 401(k) altogether, and suggest that some conservative investors aren’t taking enough risk in their retirement plans. In other words, I’m probably going to criticize any number of my readers this week.
For starters, too many investors put a great deal of their 401(k) allocation into their employer’s stock. It’s tempting because the employer often offers a generous match. Furthermore, many employees believe that their company has tremendous prospects, making the stock a wonderful investment. In some cases, employees may actually feel pressure to support their company by betting their retirement nest egg on their company’s stock. It’s an extremely unsound investment practice.
By allocating a great deal of your 401(k) to company stock, you are doubling up your bet on your employer. Your salary and any bonus are dependent on the company. In addition, you may have received some restricted stock or stock options from the company. If the company hits a rough patch, you are going to find that both your current source of income and your future source of retirement may be in jeopardy.
All too many North Carolinians learned this painful lesson as textile manufacturing waned, the telecom bubble burst, and the credit crisis hit the banking industry. As a corollary, you should also avoid the temptation of investing in a sector fund representing your profession or industry. For example, you may love the prospects of biopharmaceuticals, but you are already taking plenty of risk through your job and your ownership of your company’s stock.
On the other end of the spectrum, some folks sign up for the 401(k) program and then let the money sit in the cash option. If you are going to sit in cash, you might as well not have a 401(k), since the cash will never accumulate into anything resembling a worthwhile retirement asset; the penalty for extracting the cash is relatively high. While I’m a big advocate for making a commitment early in one’s career to retirement savings, it doesn’t make much sense if you aren’t going to invest.
Many 401(k) programs feature software or a written questionnaire that enables you to figure out your tolerance for risk and thereby determine the asset allocation for your retirement plan. After answering a series of questions, you are usually placed in a conservative, moderate, or aggressive box. As a result you’ll wind up with a small, modest, or large exposure to stocks or equity mutual funds. After completing the survey, you’ll probably feel that you’ve got a reasonable handle on allocating your contributions within your 401(k).
However, there’s a major flaw in these surveys. Even if you don’t take a risk tolerance survey and take a more intuitive approach to asset allocation in your retirement account, you’re still likely to come up with the wrong allocation. In fact, investors make the same mistake in their IRAs. Typically, investors fail to consider their other investment assets before allocating their retirement assets.
Let’s suppose you have a couple of CDs or municipal bonds in your taxable or savings accounts. When you set up your 401(k), your overall asset allocation didn’t encompass all of your assets. Thus you may have inadvertently become overly conservative. For example, as a conservative investor you may have put 40 percent of your 401(k) allocation into stocks and 60 percent into bonds. However, if your 401(k) is your only exposure to the stock market, your overall allocation to stocks may be much lower than 40 percent. In other words, you are being too conservative.
Most of us don’t have the time or inclination to build financial models or make adjustments to account for taxable and tax-deferred accounts. Nevertheless, all of us have access to an unlimited supply of unwanted credit card solicitations. Here’s how to make good use of at least one of those offers without even opening the envelope:
Turn the envelope over and set up a simple matrix with name of your different accounts down the left side and stocks, bonds and cash in the headings. Grab your latest set of bank, brokerage, and 401(k) statements, and put in the dollar amount for each asset class. Add up the total for cash, bonds and stocks and calculate the percentage for each asset class. You are likely to find that your 401(k) and/or IRA could have a greater allocation to equities without keeping you awake at night. By the way, don’t forget to shred the credit card solicitation.
Too many selections
Earlier this year I wrote about the 1/N heuristic, which is the tendency of some investors to allocate an equal amount to every option in a 401(k) plan. Unfortunately, the same folks probably make the same mistake in their child’s or grandchild’s 529 college savings plan. Many 401(k) plans have dozens of options with all sorts of enticing names such as “strategic growth” or “preferred income.” Rather than sorting through all these possibilities, it’s simpler to tick every box. While this strategy is easy, it will undoubtedly distort your asset allocation, subject your account to unnecessary expense, and create a huge amount of superfluous diversification.
Even if you don’t check all the investment options, you may be making too many selections. Most stock mutual funds are adequately diversified by the time the manager has selected 40 to 50 stocks. However, most managers actually use 80 or more securities. So by the time an investor has picked four or five equity funds, he’s already too widely diversified, and his composite return is likely to behave like a poorly performing index fund. Two or three equity funds ought to be enough. The fixed income portion of a 401(k) shouldn’t require more than one or two funds to do the job.
An investor should be able to build a 401(k) portfolio with five to seven funds. For those of you who believe in index investing, two or three funds should do the trick. If you use more, you’re going to find that it is harder to track your results, and you won’t be deriving any appreciable benefits from the added products. If you feel compelled to own your company’s stock in your 401(k), try to keep the allocation as small as possible. You are showing your loyalty by working hard. You shouldn’t have to put your retirement at unnecessary risk.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/