The Market is Crazy. Is My 401(k) OK?
If you are like most people, the majority of your exposure to the stock market is in your retirement savings. When stocks are going up, your account balance is rising and there’s little need to ask questions. As long as you’re making money, you’re not worried about understanding how or why.
What happens when your account balance starts falling though? When the stock market starts showing up on the evening news, do you get a little nervous? Maybe you start asking yourself some questions…
- Am I invested correctly?
- Why are stocks going down?
- What if the market keeps going down?
- Should I stop investing and move everything to cash?
One positive that comes out of a market correction is that it stimulates more interest in retirement saving. Complacency is easy when markets rise, but falling markets tend to force people into action.
So how do you know if you are invested correctly? Well, that’s a very personal question. There isn’t a one size fits all answer. Everybody has different goals, personalities and time horizons. Every retirement portfolio I review comes with its own set of challenges. There are however, certain reoccurring themes I see across most retirement portfolios that investors should seek to avoid.
Lack of Diversity
Diversification seems obvious but it is always worth repeating. Diversifying your portfolio in an employee-sponsored retirement plan can be challenging. The investment options available are usually limited, but you have to work with what you’ve got. Most 401(k) plans will have access to U.S. stock funds, foreign stock funds and fixed income funds. If you’re lucky, you might also have access to other asset classes such as REITs or commodities. Spreading the dollars across different types of investments will lower the overall risk of your portfolio by ensuring you don’t have too many eggs in one basket.
Review your options and come up with a diversified asset mix that makes sense. As the saying goes, diversification is the only free lunch.
Over-allocating to U.S. stocks is a common mistake I see many investors make. In all likelihood, the majority of investment options in your plan are going to be U.S. based equity funds. This isn’t because U.S. based equity funds deserve the biggest allocation in your portfolio though.
It isn’t unusual for me to see someone with 80% of their 401(k) portfolio invested in U.S. stocks. While that allocation has done very well over the past six years, there’s no guarantee that its success continues. If 80% of your portfolio is invested in the U.S. stock market, a 20% correction would wipe out 16% of your assets!
Given that only 50% of the market cap for global equities is in the United States, consider splitting your stock allocation between the U.S. and foreign equities. This will lower your risk and allow you to take advantage of more global opportunities.
Keep a close eye on your investment fees. Many people don’t realize that the mutual funds within their 401(k) plans charge a fee. Why don’t people realize this? Well you don’t get a bill in the mail for your mutual fund fee. The fee is deducted from the price of the mutual fund so its cost is somewhat hidden and rarely reviewed by the end investor. Out of sight, out of mind.
Avoid high fees. A 1% fee might seem negligible, but over long periods of time it will add up.
Actively Managed Funds
The funds with the highest fees are usually actively managed funds. Actively managed funds do not track indexes (although most have very low tracking error) and rely on the fund manager to actively select the fund’s holdings. They charge a higher fee because they perform better right? You get what you pay for, right? Not really…
Many academic studies have shown that half of actively managed funds tend to underperform their benchmark. Beyond that, it is extremely difficult to tell which funds will outperform ahead of time. A 2010 Morningstar study actually showed that the most reliable predictor of future performance was…fees!
Whenever possible, use low-cost index funds to build your allocation, not actively managed funds.
Target Date Funds
Target date funds are common in 401(k) plans. They are a simple way for an investor to diversify their investments based on their investment time horizon. They are also a great way for fund companies to collect high fees from lazy investors! These funds tend to be expensive, equity-heavy and too reliant on U.S. stocks.
The good news is, most plans have enough options available that you can build your own target date fund. Not sure how you should allocate? Look up the target date fund you were thinking of investing in on Morningstar and see how it is invested. That’s a good place to start.
If you have 15 minutes a year to rebalance, you should be able to construct a cheaper, more diversified portfolio than any target date fund will offer.
Automatic Investment Services
Many employee sponsored retirement plans offer automatic investment services that pick investments for you. Since so many people aren’t comfortable picking their own investments, opting into this type of service is quite common.
These services are similar to popular robo-advisors only are typically much more expensive and use much higher cost investments. A double whammy for the 401(k) investor and an easy money maker for the 401(k) plan administrator.
In my experience, I think most investors would be much better off managing the portfolio on their own. Advice from a financial advisor on how best to allocate your 401(k) can be had for a cost much cheaper than what these services typically charge. Once you have an appropriate allocation, taking a half hour each year to rebalance your portfolio shouldn’t be too burdensome.
Spending just a little time to better understand how your portfolio should be allocated will save you a great deal of money in the long run.
Adding Up the Little Things
Let’s take a look at three portfolios and see how an average investor can save big bucks with just a little bit of effort.
Portfolio A is invested in actively managed funds that were chosen by an automated investment service. The fund fee of the portfolio is 0.89% and the automated investment service fee is 0.65%.
Portfolio B is invested in a target date fund. The fund fee is 0.75%.
Portfolio C is invested in a diversified mix of index funds. The fund fee of the portfolio is 0.25%
Starting Value: $100,000
Annual Contribution: $10,000
Investment Time Frame: 25 Years
Annual Growth Rate: 7%
We assume that investment returns (before fees) is 7% across all three portfolios and that the only differentiator of returns between portfolios will be the fee costs.
As you can see, the portfolio fees make a big difference. A difference of 1.29% in fee cost between Portfolio A and Portfolio C resulted in Portfolio C having $249,221 more than Portfolio A after 25 years! I bet you could find a few good ways to use an extra $250,000 when you retire. I know I could.
Call to Action
So the moral of the story is, be vigilant! If you haven’t been thinking about your retirement investments or other savings, consider the recent stock market turmoil a not-so-friendly reminder to do so. If you’re overwhelmed by the thought of tackling your finances or just don’t have the time, consider hiring a fee-only advisor to help. The year is young. Get 2016 off to a good start. Stop delaying decisions that will improve your odds of future financial success. You’ll worry less and sleep better.