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7 Basic Investment Concepts Every 401k Participant Must Understand

June 25
00:46 2013

The evidence overwhelmingly indicates most employees have a problem saving. That’s why focusing their attention on savings is critical to their achieving retirement success. There are those few, however, who are well on their way to 475767_10879407_investing_stock_xchng_royalty_free_300saving enough and who have the time, resources and interest to devote to learning the art of investing. These folks generally belong in the “Do-it-Yourself” category of a tiered fund option menu.

With that in mind, we polled several prominent investment advisers and asked them the identify the most important investing concepts 401k participants should understand. Here’s the top seven:

1. The Risk-Return Relationship: The “Soundbite of the Century,” courtesy of Harry Markowitz and what eventually became known as “Modern Portfolio Theory” states “risk and return are related.” As you take on more risk, you increase your odds of scoring big gains. Of course, there’s a flipside to this many would prefer to ignore. “Investors often assume that taking more risk means you will make more money. This is not always true,” says Amy Rose Herrick, an Investment Advisor Representative with offices in US Virgin Islands and Tecumseh, Kansas. Herrick continues, “What this does mean is that your account values may swing up and down more than a lower risk more stable value option. Those swings will work for or against you depending on when you plan to retire or when you will start spending the money accumulated in those assets. Investors in early 2001-2002 and again in 2007-2008 were horrified that investments that had been performing so well dropped as much as 30-50% quickly. Many of them erroneously thought that being labeled “moderate conservative model” meant that kind of loss couldn’t happen to me- it did. If they were planning to retire, they were out of time to ride out a recovery that would take several years to again be at pre-drop levels, if ever depending on what they were invested in. The choice was to either retire with 50% of the income you planned on by selling investments for less than you paid for them in many cases that would never recover or work longer to increase the balances again. Many individuals we all know were forced to work longer to rebuild savings, it really was not a choice. Understanding the risk and potential performance swing level of your investments is crucial to your financial well-being.

In the end, though, there is no “one right answer.” How each individual manages the risk-return relationship will be up to that individual. “Know yourself and manage risk appropriately. It’s important to get your mix right, especially early, because mistakes can have long-lasting effects,” says Gary Pattengale, a Wealth Manager for Balasa Dinverno Foltz LLC in Itasca, Illinois.

2. Diversification: In one of the greatest ironies of modern investing, advisers often misquote Mark Twain as saying “don’t keep all your eggs in one basket.” In fact, he said just the opposite. He said “Keep all your eggs in one  basket and watch that basket!” In other words, we can’t ignore the costs of diversification. Ol’ Samuel Clemens was advising us not to overextend our resources and just to simply stick to what we know. Still, the concept of diversification is important. “The market is fickle, and the most successful way to deal with that is to spread your risk. If one category is not performing well, only a portion of your portfolio is impacted, rather than the entire account,” says Ozeme Bonnette, Financial Coach at Tri-Quest Investment Advisors in Torrance and Fresno California.

Still, don’t lose sight of Twain’s adage. Lauren G. Lindsay, Director of Financial Planning at Personal Financial Advisors in Covington Louisiana, says, “Diversify appropriate to YOU. Just because the guy next to you is doing it, doesn’t mean it is right for you. Most plans now include some kind of risk test, good idea to take it. And age is not an indicator of risk. We have ultra-conservative 20 year olds and super-aggressive 70 year olds so things tied to age are not always appropriate.”

3. Asset Allocation: “Asset allocation means how much money you will have allocated to each type of investment,” says Thomas Batterman, Principal at Financial Fiduciaries/Vigil Trust & Financial Advocacy in Wausau, Wisconsin. “So for example, if we look just at the broad categories of stocks and bonds and define stocks as risky and bonds as safe, what percentage should you have in stocks and what percentage should you have in bonds.  It can and should go further than that the more money you have to invest as you might get into suballocations within your stock investments of allocations to “safer” stock investments versus more “risky” stock asset classes.  But at the end of the day it is about how much you will invest in each asset class.  There are again numerous online resources to assist with education on this point.  In the way we work, clients hire us to do this kind of stuff for them because they don’t understand much about it and don’t want to take the time to learn.”

Christopher Long, President of Long Financial Planning in Chicago, Illinois, says, “Investors can develop an asset allocation that best fits their time horizon (younger=more risk, older=less risk), tolerance for short -term decline (take 50% of the stock allocation to determine the potential short-term loss e.g. 50% stock means a 25% potential short-term loss), and long-term growth rate.  (Stocks have averaged 9-10% over the long-term, bonds 5-6%).”

4. Time is on Your Side:  Elle Kaplan, CEO & Founding Partner of Lexion Capital Management LLC in New York City, says, “The beauty of investing lies in the ability of your wealth to grow over a long period of time. The short-term market “noise” is not what matters. With a sound investing strategy and a well-diversified portfolio, there is no need to follow the day-to-day ups and downs.” Long adds, “Often 401k plan investors save too little or do not invest in their 401k plan because they think they can ‘catch up’ later when they will be able to save more. This is especially true of young investors. They do not realize that for each 8-9 years they wait to start investing the amount they need to invest doubles. (e.g. if they needed to save 5% of their income at age 22, they will need to save 10% if they start at age 30, and 20% if they start at age 38).”

5. Don’t Time the Market: Here’s a classic problem that lures many naïve investors into its trap with the promise of riches. Unsuspecting 401k investors “chase performance and buy whatever was up the most last year. Then, when it goes down, they sell it and buy the next best performer, and so on. It’s a losing game,” says Pattengale, who further warns, “Don’t engage in dangerous market timing. Very few can do it successfully especially over long periods. The best chance to succeed is by picking an allocation you can stick with in any market environment.”

Bonnette says, “Timing the market means trying to keep up with what is ‘hot’ and moving funds from one opportunity to the next, hoping to maximize returns. It is important not to time the market because the majority of investors who chase ‘hot’ ideas usually perform worse than those who create a well-diversified portfolio. Most often, by the time the news reaches the masses, the biggest part of the market run-up has already occurred, and it is too late to get maximum value. If the ‘hot’ market suddenly runs cold, the chances are greater for losing a lot before moving the money out. Ignore the desire to shuffle your portfolio every time the media reports ‘breaking news.’ Stick to your diversified portfolio!”

6. Pay Attention to Fees that Matter: There’s a lot of talk about fees since the Department of Labor required service providers to fully disclose fees. Noah Greenbaum, Director of Portfolio Management at Canal Capital Management in Richmond, Virginia, says, “Many investment and insurance companies load up participant fund options with their own proprietary mutual funds because it helps pad their bottom line.. So I would encourage every participant to research what proportion of the funds available on the platform are owned by the 401k offering company. This is important because we need to ensure that investors are getting objective advice. The ultimate goal of the 401k is to build a retirement nest egg for plan participants, not executives on Wall Street. I would also encourage participants to ask their employer to use a 401k platform company that does not even have proprietary investments, thus avoiding conflict altogether.”

Batterman says, “Costs inside mutual funds can make a huge difference in the long-term performance of your investments. It is important to take a look at the cost structures of funds you might use.  Cheaper is not always better – if it were, K-mart would still be a thriving enterprise. But cost is a factor.”

7. Monitor and Adjust as Needed: Unlike 401k investors who choose the “Do-it-For-Me” categories (i.e., those who want professionally managed portfolios and who will often choose just a single fund), those in the “Do-it-Yourself” category will need to spend more time monitoring their investments. Bonnette says, “Choosing a well-diversified portfolio is not a one-time thing. The investments should still be monitored regularly and adjusted when needed. If an investment is not performing well compared to comparable/similar opportunities, it may be time to shift. Rebalancing (adjusting asset allocations among the investment options) is also importantto make sure that the portfolio does not become less diversified due to market performance. An investment option that is good today may not be good forever. Managers change, company dynamics change, etc. It is important to stay invested, but that doesn’t have to mean staying in the exact same investments forever. When other, better options are available, it will make for a stronger portfolio outcome. Monitor your investment options when the statements arrive. Monitor the other options available. Be willing to switch to comparable/similar options if what you’re holding is no longer doing well.”

What all these basic concepts come done to is focusing on process over outcomes. Michael T. McKeown, Director of Research at Aurum Advisory Services in Mayfield Village, Ohio, says, “Investors cannot control the outcomes of the markets, but they can control the investment process. This is important because behaviorally, our feeble human brains often want to change course when our portfolios run into turbulence. If we can harness our emotions and stick to the process laid out from the beginning, investors can be buyers from others that may be liquidating at inopportune times or selling to uneconomic buyers.”

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s 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 concepts outlined here.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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