More on 401(k) Choices

Posted on October 27, 2014 by Dr. David Edward Marcinko MBA MEd CMP™

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Studies, Research, Experiments and Experience

By Rick Kahler MS CFP® http://www.KahlerFinancial.com

Rick Kahler MS CFPHere is a conversation I’ve had too many times: An acquaintance says proudly that he invests the maximum into his 401(k). I ask what allocation he’s made between equities and bonds.

He says he just divides his contributions equally among the four investment choices the plan offers. I cringe.

The Book

While it’s wise to put the maximum into your 401(k), it’s also important to choose the right investment options. This is difficult for most people, as shown in the 2004 book, Pension Design and Structure, by Olivia Mitchell and Stephen Utkus.

The Study

In one study, participants were asked to allocate their 401(k) contributions between two investment funds. The first group was given a choice of a bond fund and a stock fund. A second group was given the choice of a bond fund and a balanced fund (50% in stocks and 50% in bonds). A third group was given the choice of a stock fund and a balanced fund.

In all three cases, a common strategy was for participants to split their contributions equally between the two funds offered. Yet because of the difference in the funds, the asset allocations of each group differed radically. The average allocation to stocks was 54% for the first group, 35% for the second, and 73% for the third.

The Experiment

In another experiment, participants were asked to select investments from three different menus offering options with varying degrees of risk. Most made their choices simply by avoiding both the high-risk and the low-risk extremes. They didn’t select a portfolio from the available options based on the appropriateness of the risk each presented.

Investing your retirement funds in such a haphazard manner is almost the same as playing the roulette wheel. A portfolio with 35% in stocks will perform very differently than one with 73%. Especially if you’re young, holding the portfolio with the 35% stock allocation or the 73% may mean a significant difference in your retirement lifestyle.

Another Study

In another study, when employees were given a choice between holding their own portfolio or that of the average participant in the plan, about 80% chose the average portfolio. That’s like going into a clothing store and telling the sales clerk, “Just give me a suit in whatever size you sell the most.

Implications

These studies suggest ways employers can help employees make better investment decisions. One strategy is to reduce their investment choices to a small number of funds that offer portfolios with an asset allocation based on various target retirement dates. Another is to offer employees a variety of investment choices, along with guidance and education so they could make intelligent choices.

My Experiences

In my 30 years of investment experience, the strategy I’ve seen work the best is having a wide variety of asset classes (global stocks, global bonds, treasury inflation protected securities, real estate investment trusts, and commodities) that do well in a variety of economic scenarios. A study reported on by Peng Chen in Financial Planning in 2010 found that from 1970 to 2009, a portfolio with a minimum of 10% to a maximum of 30% in each of these asset classes out-performed portfolios that did not have commodity exposure. Splitting 401(k) contributions equally among these asset classes would provide a greater chance of having an appropriately well-balanced portfolio.

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Spreadsheet

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Assessment

Once you’ve chosen a variety of asset classes, then keep your hands off except for periodic rebalancing. True, this strategy means that in any given year your portfolio will always have winners and losers. Yet with a broad range of assets, the losers and winners tend to balance out. Over the long run the odds are good that you will do fine.

Note: Ditto for 403(b) plans.

More:

Conclusion

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One Response

  1. George, on December 18, 2014 at 1:12 PM said:

    Financial Knowledge and 401(k) Investment Performance

    By Robert L. Clark, Annamaria Lusardi, Olivia S. Mitchell

    NBER Working Paper No. 20137
    Issued in May 2014
    NBER Program(s): AG

    Using a unique new dataset linking administrative data on investment performance and financial knowledge, we examine whether investors who are more financially knowledgeable earn more on their retirement plan investments, compared to their less sophisticated counterparts. We find that risk-adjusted annual expected returns are 130 basis points higher for the most financially knowledgeable employees, and those scoring higher on our Financial Knowledge Index have slightly more volatile portfolios while they do no better diversifying their portfolios than their peers.

    Overall, financial knowledge does appear to help people invest more profitably; this may provide a rationale for efforts to enhance financial knowledge in the population at large.

    NOTE: The NBER Bulletin on Aging and Health provides summaries of publications like this. You can sign up to receive the NBER Bulletin on Aging and Health by email.

    http://www.nber.org/papers/w20137

    You may purchase this paper on-line in .pdf format from SSRN.com ($5) for electronic delivery.

    George

    Like

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