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The 2 Least Understood Investment Rules that Most Hurt 401k Investors

April 16
00:04 2013

We’ve seen how over-cautiousness falsely leads 401k investors to invest in “safe” options that end up not being safe. It turns out other “common sense” behaviors actually work in an opposite fashion than expected. We can blame this counter-836077_40121333_elephant_stock_xchng_royalty_free_300intuitive sense on a lack of understanding of some very mundane investment basics. If only 401k investors really understood these basics, they’d be less like to commit errors that may hurt their chances for a comfortable retirement.

We’ve all been told of the importance to avoid placing all our eggs in one basket. This appears to make sense. After all, if anything ever happens to one basket, we still have several others to count on. Of course, what they don’t tell you is the cost of this strategy. Think of it this way. Say you have to hire a “basket” guard for every basket you have. That tends to get expensive, especially the more baskets you have. Pretty soon, the value in the basket equals the cost of the guard. This calls into question the veracity of the entire strategy. It also lends credence to Mark Twain’s advice which is to “put all your eggs in one basket AND WATCH THAT BASKET!”

This translates very easily in the world of investing. First, we know academic research suggests the optimal portfolio size is between 30 and 50 stocks (for more on this, read “A Trip Down Memory Lane – Revisiting Portfolio Optimization,” FiduciaryNews.com, October 26, 2011). Beyond this number, the cost of diversification tends to eat away at the portfolio’s investment performance. This leads to the first reality that most 401k investors must deal with – the average number of holdings in the typical mutual fund far exceeds this optimal portfolio. This means, even if 401k investors were to select only one fund, chances are they would already be over-diversified.

But it gets worse.

Too many 401k investors assume they must diversify among mutual funds, forgetting that mutual funds themselves are already diversified portfolios. We define over-diversification as the tendency to buy too many mutual funds; thus, create a high-fee index fund. Why do so many retirement investors believe they should buy more than 2-3 mutual funds, which in themselves are already diversified portfolios?

“Because there is limited transparency and knowledge that similar funds hold the same investments,” says Craig Morningstar, COO at Dynamic Wealth Advisors in Phoenix, Arizona. “Most retirement plan investors are told to buy more funds, and they have no way to know there is overlap of holdings.”

Tad Hill, president of Freedom Financial Group in Birmingham, Alabama, says, “The issue of over-diversification doesn’t get explained to people very well. This is especially true if all of their savings are inside of a 401k plan. There may be no one that is giving them any education on how to allocate their portfolio.”

“It all comes down to context,” says Gabriel Potter, Senior Researcher, Westminster Consulting, in Rochester, New York. “Investment consultants have been banging the drum of the benefits of diversification for decades, so it’s not surprising that some investors have absorbed the lesson but misapplied it.” Potter asks that, since “investors have been sold on the idea of diversification, so isn’t having more than one fund better as well?”  He points out, “The drawbacks are obvious to professionals, but require a little thought.”

Unfortunately, many 401k plans have been designed to automate processes which lead to these naïve diversification strategies. “Many 401k’s are set up to have online service and management of the portfolio by the individual removing one on one advisor interaction or discussion,” says Amy Rose Herrick, an investment adviser representative and Agent in Christiansted, US Virgin Islands. She continues, “On the web site, generally a few questions are answered to determine a preset ‘model.’ The investor elects a model. Using the model selected assets will be divided into a percentage based model between multiple funds. If offered, investors may pick a target date fund instead of a model. Perhaps a metering device will show if a fund is low risk, moderate or high risk in some visual format. However, this does not mean that either election the client has chosen to use will be the right answer. Clients using any of these methods will likely not be able to identify if the down side risk is within their tolerance levels either. I feel this design assumes all investors are well informed and know exactly what they are selecting. It is my opinion this is far from reality.”

To address these design failures, many 401k plans are moving towards a one-portfolio solution. These “lifestyle” funds, not to be confused with the popular (but still unproven) target date funds, are more akin to traditional balanced profit sharing plan portfolios. As such, they represent a single portfolio managed towards the needs of the plan demographics. Typically, these is single option default fund meant for 401k investors who want to concentrate on saving and not worry about making an investment decision.

“There are a number of advantages towards simplifying a portfolio,” says Potter. “First, this is simply the application of limited returns – adding more funds to a properly diversified portfolio will only have a marginal impact. Second, there is a finite amount of time allotted for due diligence – simplification allows for great depth of understanding instead of spreading this time between too many funds. Third, as already suggested, combinations of managers often (unintentionally) counter-act active bets. Manager A’s actions may offset the active bets of Manager B – in other words, you’ll end up with combined passive performance at active fees. Finally, adding more options can add to indirect costs because of extra accounting, error checking as well as the aforementioned direct costs (i.e. preventing advantageous breakpoints for large purchases).”

Morningstar agrees. He says, “If the single portfolio can produce better results than a self-designed portfolio, all the better for the plan investor. Improving better outcomes is where the true focus should be, which is different than just higher returns.”

These “One-Portfolio” single options differ from target date funds in that they are not managed to a theoretical retirement date but to a consistent demographic. This bypasses the confusion related to “which date are we talking about – retirement or death?” Again unlike target date funds, “one-portfolio” funds rely less on asset allocation models and more on traditional investment management. (“Old time portfolio management. Just like Edie Shore. And Ben Graham.”)

Of target date funds, “the asset allocation models used to construct these portfolios are not necessarily congruent with what we would call prudent investing,” says Patrick Hejlik, CEO, Fourth Quadrant Asset Management, Danville, California. “They are based on historical preferences and data on what someone who is ‘x’ years old ‘should’ have and this could be on faulty assumptions.”

Asset allocation takes the idea of diversification within stock portfolios and spreads it out among different asset classes. Twice in the last ten years (2003 and 2008/09), the market collapse consumed all asset classes, leaving both professionals and the average investor to wonder if asset allocation is dead. “Investors got burned on asset allocation models in 2003 and 2008/09 because the underlying assumptions on how the assets would behave in a downturn were faulty,” says Hejlik.” This is a common problem when using historical data to make asset allocation models and using securities that are not designed to profit when markets become dislocated.”

“Diversification is a necessary component of portfolio construction, but it insufficient to protect against all types of risk,” says Potter. “We might argue that investors who were truly honest with their consultants about their genuine risk tolerances have been reimbursed over time for the market downturns in 2003 and 2008/09. Rather, we suggest that a scenario based analysis for generating an investment policy and the discipline to apply it is more important. However, if investors believed that asset allocation alone was sufficient to protect them from precipitous drops in their portfolio balances, the past decade has been a painful lesson in the limits to historically driven models and modern portfolio theory.”

Andrew Wang, Portfolio Manager, Senior Vice President in Runnymede Capital Management, Inc., in Mendham, New Jersey sums up what all 401k investors should know: “The industry preaches the benefits of diversification so most investors desire to own more than 2-3 mutual funds. Most advisors aim to balance risk through asset allocation by owning all major asset classes such as cash, bonds, stocks, real estate and commodities. In theory, each asset class has different levels of risk and return and is supposed to create a portfolio of uncorrelated assets, meaning that when one went down, another went up. However, in [2002 and] 2008/09, virtually all asset classes moved in tandem, and they declined in unison.”

Like the proverbial elephant in the room, it comes down to these two basic investment facts: 1) The optimal portfolio size is 30-50 stocks (well below the average number of holdings in a typical mutual fund; and, 2) asset allocation has proven a false siren when times are worse. At least some professionals believe it makes sense for the average 401k investor to consider the “one portfolio” approach as the most efficient solution to the investment question.

But let’s not get too cocky. There remains one more “over” bearing emotion that hurts 401k investors. We’ll discuss that next week.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

 

 

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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