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Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees

August 30
00:28 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Here’s one that’ll stump too many professional financial advisers. It’s a totally unrealistic example, but it’s like one of those “boundary condition” tests physicists likes to use. It’s unlikely to ever happen, but it presses a theory to the extreme; 667182_25421374_amphitheater_stock_royalty_free_300thus, allowing one to assess the validity of any hypothesis. Here’s the scenario: You have a chunk of money that needs to earn 10% over the next twelve months to send Johnny to college. (Again, this is a boundary condition test that – we hope – will never happen in real life.) You have only two investment options. The first investment option has a standard deviation of 30% (meaning there’s a 67% chance the annual return will fall between -30% and +30%). The second investment option has a standard deviation of 0% and guaranteed return of 5%. Here’s the question: According to Modern Portfolio Theory, which investment option poses the greatest risk?

In the ivy covered halls of academia – and in most of the Monte Carlo simulators practitioners have come to rely on – the investment option with the greatest risk is the first option. Why? Because Modern Portfolio Theory uses standard deviation as a proxy for risk. After all, isn’t the guaranteed return offered by the second investment option the very definition of a “risk-free” investment.

This brings us to the awful and misleading nature of risk and Modern Portfolio Theory: it places the focus of risk on the investment, not the investor. In the above example, would an investor who needed a 10% return be happy with the “risk-free” investment? Absolutely not! Now he’s got to live with Johnny another year instead of sending him off to some distant university. In fact, an investor who needed a 10% return might, after speaking with the appropriate attorney, turn around and sue the adviser who placed him in the second investment option rather than the first investment option. How could this be so? By placing the investor’s assets in the second investment option, the adviser only guarantees the investment objective of a 10% increase will not be met, thereby causing Johnny to fall behind his scholastic peer group and the school lecture hall to have another empty seat.

Johnny’s sad disposition yields the only important definition of risk: failure of the investor to meet lifetime goals directly as a result of failing to meet investment goals. All the Capital Asset Pricing Models and all the Black-Scholes Equations cannot send Johnny to school if the investor doesn’t make that 10% target.

By this point I’m sure some readers are quite upset about this boundary condition test. Rest ye weary brains, ‘twas done with purpose in mind.

The problem with risk starts with its most appealing, most common-sense trait. It’s what we call Modern Portfolio Theory’s Sound-Bite of the Century, namely, “risk and return are related.” This philosophically attractive relationship pleases those who abide by the maxim “no pain, no gain.” But at what point does the carrot become the stick and the stick become the carrot?

Let’s do another thought experiment, this one a little bit more believable. Suppose, one night, the ghost of John von Neumann, vaunted member of the Manhattan Project and the father of modern game theory, appears before you (OK, so this part might not be too believable). Undisturbed, you casually rub the sleep from your eyes as he materializes. This Johnny – who definitely had the benefit of post-secondary education – offers to give you $100,000. He says you can invest it any way you want and keep any gains. He just wants the $100,000 back after twelve months.

Where would you invest the $100,000 if:

  • After twelve months, your failure to give it all back to von Neumann will result in a $100 penalty; or
  • After twelve months, your failure to give it all back to von Neumann will result in a $100,000 penalty?

Now, here’s the important question: How would your answer change if, instead of twelve months, von Neumann gave you twelve years to give him back the original $100,000? In this game, the key parameter isn’t the return requirement, but the time limit. In shorter time frames, investors tend to act more conservatively. This hurts their long-term investment performance. With a longer time frame, an investor is more likely to invest in growth-oriented investments. Ergo, they tend to achieve greater returns than their myopic counterpart.

In real life, especially for retirement, you only get one chance at this game. While it’s understood anyone can get dealt a bad hand, it’s probably a good thing for a 401k plan sponsor to structure a plan that encourages employees to have the discipline to take the long view. Here are three easy practices an ERISA plan fiduciary can implement to avoid Myopic Loss Aversion, one of the common investing mistakes identified by researchers in the field of behavioral finance:

  1. Avoid daily, monthly or quarterly reviews of your portfolio’s performance.
  2. Review investments at most annually.
  3. In this annual review, don’t focus on yearly performance numbers, and, if possible, look at performance over the last three years or, preferably, the last five years.

Famed behavioral economist Richard Thaler has said, “Loss aversion doesn’t matter if you take a long enough view because there are essentially no losses” (Dow Jones Fee Advisor, Sept/Oct 1996, p. 26). Don’t be misled by the formal name of this malady. Remember the subject of this article. Keep your eye focused on the real risk: Not meeting your investment objective.

It takes a lot of discipline not to get excited about market volatility. Applying the three practices above helps prevent employees (and even plan sponsors) from paying too much attention to wild swings in investments. That said, one should not forget, if the assets are professionally managed, volatility can represent an opportunity.

As we end this series on the Second Deadly Sin, remember how we began. Investment advisers do not act as “risk managers,” but really perform duties similar to “loss control managers.” The former implies managing risk which, in itself, is unimportant. What is important, however, is the bottom-line, as implied by the latter. Losses cannot be prevented, only controlled and managed so as to not lead to a catastrophic event. In practice, this means the selection of securities which exhibit a higher upside potential than they do downside potential. In other words, you don’t want your portfolio manager diverting himself unnecessarily with the precise definition and measurement of risk (which can never be precisely defined or measured). Instead, you want someone who understands the world is not perfect and that losses can and will occur and focuses on the managed control of those losses.

Epilogue: What to do if you still can’t shake the notion that personal risk tolerances must take priority in selecting an appropriate investment strategy. Here’s a story Richard Thaler wrote of in his book Nudge. In it, he cited the research paper “Priming and Communication: The Social Determinants of Information Use in Judgments and Life-Satisfaction,” (Fritz L. Strack, L. Martin and Norbert Schwarz, European Journal of Experimental Psychology 18 (1988): 429-42). In this experiment, college students were first asked “Are you happy?” and then asked “How often do you date?” The researchers found no correlation between being happy and dating.

Next, a similar survey of college students was conducted. This time, researchers first asked “How often do you date?” and then asked “Are you happy?” In this new study, they discovered a correlation now existed as people who dated less often tended to be less happy.

What does this tell us? If you want to be happy, don’t think about your love life. Seriously, the results suggest the order of questions in a survey can influence responses. In behavioral economics, we call this activity “anchoring,” as in one predecessor action acting as a reference anchor to influence a subsequent action (or decision). This is one of the reasons political polls can be controversial (especially when pollsters use anchoring to “push” respondents in a certain direction) and why it’s difficult to make public policy based on poll results.

What does this tell us about picking an appropriate investment philosophy or 401k investment option? Foremost, never consider “risk tolerance” first because it can skew perceived needs. Instead, always consider investment goals first because that is the bottom line. Once the investment goal is established, then investors can identify several possible methods for reaching that goal. Each method may – or may not – offer a different level of risk. To the extent the different methods offer different risk levels, investors can now choose their preferred risk level based on this limited set of choices which will still give investors a good chance of reaching their ultimate goal. Who knows, maybe Johnny can go to school after all.

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of “Risk”
Part II: Investment Risk and the 401k Fiduciary: An Overview of Components
Part III: The 401k Plan Sponsor’s Dilemma – What’s Wrong With “Risk”
Part IV: Why Risk Doesn’t Matter to the ERISA Fiduciary
Part V: Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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