The Three Most Common “Over”-reach Mistakes Plan Sponsors have a Fiduciary Duty to Help Retirement Investors Avoid
Many new employees can’t wait to start investing in their 401k. This might be a good thing or it might be a bad thing. Their overenthusiasm may cause them to take the wrong fork in the road. They might begin studying investments and only investments. As you’ll see in this and the references articles, these “studies,” even if from reliable sources, can amplify the investor’s likelihood of making a common mistake. On the other hand – and this often comes as a result of anticipatory actions of a financial adviser or plan fiduciary – this overenthusiasm can be redirected into a more useful set of actions.
Ironically, sometimes a lack of enthusiasm can actually benefit the retirement investor. The market downdraft of 2008/2009 hit retirement investors very hard. The fact the economy has yet to recover since then has depressed them even further. Many, like ostriches, just kept their heads in the sand. They even refused to open their statements. They did nothing.
Their counterparts felt compelled to “do something.” They studied whatever they had to study, even correctly predicting the lack of GDP recovery by the American economy. They sucked in their collective bellies and sold, knowing (correctly) it would take as long as a decade for the economy to recover.
Five years and counting, which group ended up in the better position – the ostriches who lost their enthusiasm or those who reacted with vigor?
According to nearly every report, the folks who kept their heads in the sand did better. Their retirement assets recovered more quickly and they soon returned to the course they originally set. Unfortunately, those who displayed a certain level of overenthusiasm for action, well, some of them have just never recovered. It turns out it wasn’t their overenthusiasm itself that bore the evil mark of “common mistake,” but that “over”-enthusiasm made them more susceptible to other “over”-isms that do rise to earn the title “common mistake.”
There are three common mistakes that can be classified as an “over”-reaching mistake. They occur when retirement investors are “over”-cautious, when they “over”-diversify and when they’re “over”-confident. If you consider each a “disease” (and some psychologists may), then each has several “symptoms” associated with them. These “symptoms” are a lot easier to recognize than their corresponding disease. We’ll review the general idea of each common mistake in this article and reference other articles that describe the specific symptoms.
“Over”-Cautiousness: Did you ever feel like there’s no point in taking any unnecessary chances? You just want to sit back and enjoy the fruits of your labors, without necessarily laboring any more to increase the amount of those fruits. Ever notice how some Little Leaguers have an innate ability to get on base? They no doubt, early in their careers, discovered two things: 1) They couldn’t hit the ball worth a darn; and, 2) Opposing pitchers had a hard time throwing strikes. They did the math and figured the odds were in their favor if they didn’t swing. Sure they struck out a few times, mostly when their angry coach yelled at them to swing. But more often than not, they walked. That’s what “on base” percentage means – the percentage of times you made it to base (no matter how) versus the number of at bats you have. Of course, if you don’t swing you don’t hit home runs. In fact, if you don’t swing, you don’t hit the ball. So, not only did these kids have the highest on base percentage, they usually also had the fewest hits. Unfortunately, they may have thought they had out-smarted the game of baseball by playing it safe. No so. The following season they’re usually the first to be cut from the team.
Thus is the evil temptation of “Over”-Cautiousness. You think you can win by playing it safe, but you can’t. Ironically, the only way to play it safe is by taking a chance. Without taking a chance, you’re pretty much dooming yourself to failure. Look at all those “over”-enthusiastic retirement investors who sold off after the 2008/09 market crash. They thought they were playing it safe. Little did they know they ended up taking the biggest chance of their lives – and they lost.
Interested in learning more about “Over”-Cautiousness, then read “3 (Bad) Reasons 401k Investors are Over-Cautious”
“Over”-Diversification: It seems like “Don’t put all your eggs in one basket” is an adage burned deep into those brain cells devoted to decision-making. The saying is generally (and wrongly) accredited to Mark Twain. And since Mark Twain is the American Paragon of “Common Sense,” most Americans are compelled to follow his advice. Right? Well, if you really want to do what Mark Twain advises, he didn’t say “Don’t put all your eggs in one basket.” What he really said, through a character in Pudd’nhead Wilson, was “Put all your eggs in one basket – and watch that basket!” Think about the wisdom of this. We’ve all got only so many hours in the day. With limited resources, we can watch only so many baskets. Isn’t it better to concentrate on just one basket instead of all those many baskets?
By the way, this is the first (and often last) tragic mistakes made by entrepreneurs. They start a business and think they can take over the world. They accumulate clients like it’s going out of style – until they figure out they just don’t have the capacity to serve so many clients. They can study all they want about “distribution bottlenecks” and such, but, by then, it’s too late. Service begins to suffer, clients leave and their reputation is scarred. In many industries, and especially the service industry, “boutique” business plans often work. It’s only when companies grow beyond their niche (i.e., spread their eggs among many baskets) that many begin to fail.
These companies, in essence, make an investment decision to diversify, not a business decision to vertically or horizontally integrate. While it’s not a guarantee of success, the business-based decision is usually more successful than the investment-based decision. The same is true for retirement investors. They regularly fail to realize their decision to broaden the holdings of their portfolio leads to “Over”-Diversification. This is as about as useful – and possibly just as harmful – as buying too much insurance. After all, how many times can you die and how much money does your family really need once you die. It’s a finite amount. Once you exceed that finite amount, the premium costs are no longer adding value, they’re hurting your current cash flow. You’ll have to work more hours to maintain your standard of living.
Want more about “Over”-Diversification? Try this: “Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio”
“Over”-Confidence: Every so often, you just “know” your favorite sports team is going to win. There can only be one inevitable outcome in such a situation: It will all end in tears. Each year, in any given league, only one team can win it all. That means the season will end in tears for fans of all the other teams. It’s part of what being a fan is all about. It’s that irrational (where do you think the word “fanatic” comes from) confidence that your team will go undefeated. Unfortunately, but unless you’re the 1972 Miami Dolphins (and that was only due to a controversial fumble call against those same said Buffalo Bills), “undefeated” and “season” are two words forever separated.
You want to know the worst kind of “Over”-Confidence when it comes to sports fans? Those who are absolutely confident they’re right – and have the statistical evidence to back them up. Don’t you just love to see those guys lose to your fantasy team? Funny thing about that. It is this same overreliance on statistical measures that causes retirement investors to succumb to the common mistake of “Over”-Confidence. What is this strange fascination with numbers and, in particular, statistics? Even Einstein said “God does not play dice with the universe.” In the investment field, this “Over”-Confidence derives from an old theory (called “Modern Portfolio Theory”) that held markets are efficiently rational. In other words, the theory was that people – a.k.a., investors – will always make rational decisions. When several anomalies began to appear in the theory, all the finance professors and all the Wall Street rocket scientists couldn’t put it back together again.
Finally, from a once-shunned field called “behavioral economics” came this simple question: What if man doesn’t make decisions rationally? That turned out to be the key. Once we removed the assumption of rationality, a lot of these anomalies were easily explained. Still, some stick to the old theory or its remnants. The lure of “Over”-Confidence is just too big to ignore. But the cost isn’t.
Discover more about “Over”-Confidence. Read “Detecting These Signs of Overconfidence Can Help 401k Investors Avoid a Fall”
Perhaps the most famous modern example of “over”-reach occurs in the movie Indiana Jones and the Last Crusade. In deciphering his father’s book, Indiana Jones discovers the Holy Grail. But there’s a catch. He can’t take it with him. When the evil Nazis try, the ground splits and the Grail nestles itself on a ledge just beyond reach. The beautiful Nazi agent Elsa believes she can reach it, but when she tries, she falls to her death. Indiana then nearly succumbs to the same temptation. But, unlike his ancient Greek predecessor Icarus, Indiana heeds the wise words of his father who warns him to stop. As he retreats, Indiana looks back to the old knight in the background, who nods his head approvingly, as if, again, saying, “You have chosen wisely.”
When designing plan menus, a good fiduciary will be careful to create them in such a way as to mute the alluring music of these common mistakes. Ultimately, it is the responsibility of each individual retirement investor to “choose wisely” and avoid being over-cautious, over-diversified and over-confident.
Want to see examples of how 401k plan sponsors can design plans to help investors avoid these Common Mistakes? Read Section Five of 401(k) Fiduciary Solutions to discover this and much more.
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.