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The Best Investment Advice 401k Investors Will Ever Receive

July 24
00:10 2012

Let’s start with “the soundbite of the (20th) century”: Risk and Return are related. No one can honestly deny the common sense truth of this correlation. Now, we can discuss the investment implications of it (and we’re in the process of interviewing experts now on the subject), but the purpose of this article is quite simple: to reveal the best investment advice a fiduciary – whether plan sponsor or investment adviser – can offer any 401k investor.

In maneuvering through the labyrinth of risk and return, financial professionals often find themselves hand-cuffed by regulators. The SEC prohibits them from using past performance to project future performance. In fact, the government actually requires investment advisers, whenever they show performance numbers, to include the disclaimer “past performance can never guarantee future results.” Investors want some sort of promise. Unfortunately, the industry simply cannot offer it.

This is where the challenge comes in. Better advisers will attempt to educate the investor about the true way to use return. Others simply fall back to that time-honored CYA device: The Risk-Profile Questionnaire. Before we reveal how the better advisers address return, let’s revisit the problems with “risk.” (It’s in parenthesis because, as we shall shortly see, there’s really not a universal definition of risk.)

FiduciaryNews.com featured a five-part series almost exactly a year ago dealing with the problems of “risk,” (see the first part “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of ‘Risk’,” FiduciaryNews.com, August 16, 2012). To really understand investment risk, one has to see how risk management evolved. It actually started as a form of insurance (specifically, maritime insurance). A business would identify a certain risk and place a “bet” his business would succumb to this risk. That’s what it means to insure a specific risk doesn’t scuttle your plans. You – whether “you” means an individual or a corporation – pay someone (namely the insurance company) to assume your risk. If the risk fails to materialize, you lose the amount you paid. If the risk occurs, you “win” the value of your loss (less any deductions) back from the insurance company.

In fact, investors manage risk all the time, just not in their investment portfolios. They insure their cars, their homes, their lives and this little catch-all thing called “liability.” This is not to say their investment portfolios don’t also contain risk. In fact, there’s a whole litany of components of risk when it comes to investing. The problem starts when people foolishly try to map their so-called “risk tolerance” to any or all of these components.

More than two generations ago, finance professors tried to quantify portfolio “risk.” Because of computer limitations, they chose standard deviation as the proxy for risk. There’s just one rather obvious problem with using standard deviation. This statistical element only works for samples with normal distributions, and, as studies show, investment returns are far from normally distributed. It’s actually worse than that. Even if those returns were normally distributed, standard deviation fails as a proxy for risk for common sense (there’s that phrase again) reasons.

Anyone who’s seen the movie Catch 22 or read Joseph Heller’s book might remember this scene. In it, bomber pilots receive awards for dropping bombs in the “tightest” pattern. In air force terminology, this means bombs hitting in a straight line rather than a jagged line. In Heller’s WWII masterpiece, the winning pilot dropped bombs in a perfectly straight line (i.e., he had the smallest standard deviation). Of course, he dropped the bombs in the sea far from the intended target. But they were in a straight line!

This, in a nutshell, explains the entire problem with using risk to help determine an investment strategy: it often fails to consider the target. If you’re an investment professional, here’s the bad news: The client isn’t always right. But there’s worse news: If you listen to an investors risk concerns without first considering actual needs, you’ve just assumed a greater fiduciary liability.

In our original series we ended with three easy practices a 401k plan fiduciary can implement to avoid one of the common investing mistakes identified by researchers in the field of behavioral finance. For this article, let’s circle back and answer how the better advisers have solved the risk/return dichotomy. It’s a win-win solution as it doesn’t require the adviser to hide behind mandatory disclosure (at least not right away) and it gets the 401k investor focused on the most important aspect of his retirement savings strategy.

Rather than bypassing return, the best advice 401k investors will ever receive will allow them to not just embrace the concept of return requirement, but attack it in the form of identifying a specific Goal-Oriented Target. Good advisers help 401k investors keep their eyes on the ball – their desired retirement lifestyle – and not on the latest investment fads of the strategy de jour.

It’s like the commercial on TV that has those numbers floating above retirement investors’ heads. That’s their Goal-Oriented Target. Achieving it is influenced by any number of things, including desired lifestyle, annual salary deferral, company match, retirement age and, yes, whatever kind of investment strategy they wish to employ. Of all these elements, the regulators require a disclaimer on only that last item, but that leaves at least four other factors, and investors have better control of these.

And that’s good advice for both the professional fiduciary and the 401k investor.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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1 Comment

  1. Tim Wood
    Tim Wood September 12, 12:43

    Chris,

    I echo your thoughts. When I am talking to participants, I always reinforce the argument that every pot of money needs to have a goal and that goal is what should primarily determine the investment strategy. Whether an investor has a primarily aggressive bent or is more comfortable being middle of the road, they all should have multiple investment strategies that they adhere to.

    For example, it does not matter what your investment outlook is, your emergency fund should not be invested in equities. The goal of an emergency fund is safety of principal and liquidity of the terminal sum. If your emergency need is $15,000, that money should not deviate with market returns because you have already determined that you need $15,000. Also, in an emergency, you can’t wait for T + 3. To invest this money, regardless of your otherwise general view on risk is to question your need for the money.

    The other thing I do with the plans I manage is to put together investment menus for plans that avoid unrewarded risk. Take junk bond funds, for example. Without getting too technical, junk bond funds generally have volatility that is similar to a high octane emerging markets fund. While there are exceptions to every rule, in a good year, an exceptionally good junk bond fund might make 12%. The emerging markets fund I have been using for the past nine years made something like 120%. In this example, an investor took on the risk that would have rewarded 120% but earned ten times less. Also, especially with junk bond funds, by avoiding them you limit confusion. The typical person thinks of fixed income investments as the safer bets. There is little that is safe about a junk bond fund.

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