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In this introduction we will discuss a set of popular delusions among 401K investors. Among them
Most 401K investors have illusions that their returns are higher then they actually are
Overinvestment in stocks (let's say far above what formula 100-your age suggests) might be dangerous
Many 401K invertors have absolutely no idea how their investment is doing. One often overlook problem with "bold" strategies in 401K plans is that the same percentage loss in 401K plan means more then each win and losses at the end of investment cycle mean more than wins at the beginning. Suppose you have an investment which earns 20% the first year, -30% the second year, and 10% the third year. What is its average rate of return? It is not the arithmetic mean, because on the first year your investment was multiplied (not added to) by 1.20, on the second year it was multiplied by 0.7, and the third year it was multiplied by 1.1. The relevant quantity is the geometric mean of these three numbers, which is about 0.97 or -3% total return. Cost averaging further complicates the picture: protracted period of abnormally high prices following by a slump can defeat the benefits of cost averaging.
They trust too much to their intuition that is distorted by media noise. As a result many participants in 401k plans are unable "to stay the course" and act spontaneously reallocating their portfolio, and never calculate their total annual return. In reality average returns are negative after adjusting for inflation and all what those accounts do are feeding mutual funds industry: most (but not all) participants would probably be better off buying Treasuries Direct. In other words they are unable to beat inflation and just serve as "Wall Street donors."
"Defensive reallocation moves" (and should be not equaled to just selling your stock positions and putting everything in cash) are easy to make only in retrospect. They are for sure a variant of market timing and that latter really isn't that easy of fool-proof. That's why a simple dynamic reallocation that includes your age (or the number of years before retirement) matters so much and that fact was now accepted in many "target date retirement" funds, which unfortunately usually are not available to 401K investors. Essentially it is one slow life-long defensive reallocation move.Bull/bear reallocation moves to more
defensive position in case of bubbles are possible but much more difficult as
there are always some mix of real and misleading warning signs before
real trouble starts. Often there are multiple signs of
troubles are two or even three years before real action starts.
The key problem here that even real warning
signs can come too early and
the bull market can run two, three or even five years after the problems became evident and
warning signs are abundant. Also a correction of 30% after you gained 40%
the previous year is
not a disaster. Still if you are determined to play a defensive
game you should try to diminish the percentage of stock you hold with age.
Please note that cash is safer then bonds, especially if bond funds returns below 5%.
The danger of investing in such bond funds was clearly evident in 2007.
Bond funds with returns below 5% are usually bad investment choice in 401K portfolio and cash (ultra-short
bonds) is a good competitor as for long term returns. Therefore there
can be some bond to cash rotation if bond yields drop below one percent below
this magic 5% threshold (which is actually completely unscientific and you need
to understand this).
Some analysts consider 2007 in some ways might resembles 1999 or 1998. That
means that in 2008-2010 we better be really vigilant , even if that just
means sticking to 100-your age strategy. History never repeats
as a copy and now bonds instead of stocks or along with stocks might be the
assets which lose a lot of value. New twists are guaranteed, so experience of 2001-2003
tech stocks carnage that many still
remember well can be only of limited value. If rates will be raised
considerably bonds
funds (and especially junk bonds) will suffer most. During 2000-2001 many people including
myself ignored the signs of coming troubles and did not move to a more
defensive position (and I remember having this feeling "it is time to reallocate"
in Jan 2001 but did nothing and continued to holds 100% stocks till Jan 2002).
It might be partially explained by overconfidence
in our own abilities, and information overload with strong "perma-bull sentiment"
in Wall Street financed media. Just read articles and opinion columns of "investment gurus"
from Jan-August 2001: most of them, especially from
Jeremy Siegel are pretty funny in retrospect, unless your own money were
involved. Here is one telling quote (This
Feels Like a Slump, But Is It a Recession? Published:
August 15, 2001 in Knowledge@Wharton;
please note that the quote has been edited on the original web site since it was originally published ;-)
:
Jeremy J. Siegel, a professor of finance at Wharton and author of Stocks for the Long Run, says that "qualitative judgment comes into play whenever one tries to differentiate a slowdown from a recession. My feeling is that we will not have an outright recession or even two consecutive quarters of declining GDP, but the way the economy has slowed is quite substantial. Given the prior euphoria over the new economy, the current deceleration, where growth went from 8% to 2% in the course of a year, feels just like past recessions where growth went from 4% to -2%." Siegel maintains that "events move faster in the new economy, and this can create as many problems as benefits. What must be most disappointing to new economy enthusiasts is the manner in which high-tech firms miscalculated the demand for their products. Sophisticated techniques for keeping inventories low relative to sales may have become commonplace, but even Cisco, for example, was stuck with a huge amount of excess inventory because the speed of obsolescence is so high for computer equipment. Thus, we have learned that the new economy is not immune to old economy issues that create business cycles."
See also his September Is Going To Be the Turnaround interview published on June 12, 2001 in BusinessWeek. As Dante Alighieri in early 14th century suggested in his immortal The Inferno the proper remedy might be:
This fallacy is actually a part of the expectation that somebody will provide investors sound advice about what to do with their money. Ronald Reagan used to quote old Russian proverb "Trust but verify". This proverb is perfectly applicable to 401K investing and the second part is usually completely missing. For example a lot of programmers who are perfectly able to use Excel spreadsheets (and this is a very powerful simulation tool) are investing on autopilot or worse by following some bad advice that they got from the press.
Among typical reasons for low return [(p. 217) of Amazon.com Reviews for Bull's Eye Investing Targeting Real Returns in a Smoke and Mirrors Market Books John F. Mauldin Gavin McQuill of the Financial Research Corporation list the following":
I think that for most of 401k investors the key problem is not "how to get high returns" but "how to avoid zero or negative returns after inflation" and the real task in hand is to squeeze 5% or better 6% annualized return typical for the long term treasury or AAA bonds out of arbitrary mix of investment options present in the particular 401K plan. With cost averaging, most Vanguard stock funds and indexes that I experimented with (again historical data are not guarantee of future returns) produce returns less then median returns of government saving bonds over most simulation lasting exactly ten years periods with starting dated randomly distributed between Jan 1, 1993 and June 1, 1996 (and those of those set of 10 year periods which end in Jan 1, 2003 to June 1, 2006 most contain both bull and bear markets). And if you think about it, mutual funds are just another type of for-profit commercial enterprises (Vanguard is probably an exception here; but it might be less of an exception then you think). There are few talented managers who really try their best and a lot of regular guys who have problems beating the index. Otherwise this is just an overhead that you feed and that eats the returns. All you have to do is look at the huge losses taken by popular among professionals and almost universally recommended before 2000 funds like Vanguard PRIMECAP. Who is recommending PRIMECAP now ?
The idea that dollar cost averaging is an optimal method for contributing to the stock portion of 401K isw open to review. In reality dollar cost averaging guarantees lower return then value averaging if the period is large enough
Published stock indexes returns are somewhat
misleading: in no way a typical 401K investor can get those: for ten years period typical annualized return for dollar cost
averaging of a certain sum of money is approximately 1.3-1.7 lower then return received by investing
lump sum at the beginning of the period.
For example for many
"exactly 10 periods" (say, Jan 1996 - Jan 2006) S&P500 performed worse then stable value fund
with fixed return about 4.5% if cost averaging for the whole period starting
with zero initial investment is assumed
Many “house
poor” (middle-class homeowners who stretch themselves too thin financially
to buy a large house with the jumbo loan) cannot save enough in 401K because they are slaves of
their mortgage loan. They over-borrowed; worse, they just don’t
have enough savings to cushion the impact of a divorce or job loss—two fairly
common occurrences.
Former U.S. Labor Secretary Robert Reich noted that assuming that house is essentially
"retirement fund in disguise" is open to review:
“Bubbles form when it’s easy to get capital to invest in something, and when investors assume that somebody else will come along after them and pay even more for it.” But Reich warns that when mortgage rates rise—when the easy money dries up—“buyers can no longer assume that future buyers will pay more, because some future buyers won’t be able to.” People can be stuck with more house than they can afford and no way of offloading it.
The idea that home is a safe bet investment. It safer then many others types of investment, but only the rich are cushioned from the effects of a housing slump. Less than a fifth of the assets of the top 10% of American earners are tied up in their main homes; for middle class, the equity in houses comprise approximately half of their assets. An individual mortgage is essentially a huge short position in bonds market. As such it is influenced by bonds yields and behavior of underlying currency. If bond prices go up (and "real", after inflation yield go down) you lose money and if bond prices go down (and "real", after inflation yields go up) you earn money on your short position.
Although fixed mortgage is not callable, they might also be influenced by catastrophic events (as was in case of "Katrina mortgages") and by the depreciation of the currency. Situation is definitely more complex if the annual rate of inflation exceeds 3% (1.03^30=2.42 so with 3% annual inflation means that the dollar depreciates 142% in 30 years; in reality the depreciation of dollar from 1977 to 2007 in relation to euro was faster then 3% a year; but this is not the only measure of inflation). In this case assuming you kept the house for at least 2/3 of the 30-years period "real yield" (after inflation) on the house is much less then nominal yield and you paid the down payment in most expensive dollars. Also the first half of the mortgage is paid in "old" or "higher value" currency. But when you sell it you will get "depreciated" ( approximately in half) currency for your property. Therefore the price of the house should approximately double for you just to get even. That means that much depends how well the price of the houses kept with inflation. The situation is especially bad if part of the period was consumed by a prolonged housing slump where there in no appreciation (or there is a slight depreciation -- house prices are sticky) of the value of the house. At the same time "stealth" devaluation of dollar also decrease the "real" (let's say converted to gold) interest and as such helps the borrower and hurts the lender. That's why lender tries to get the lion share of interest as quickly as possible (the first ten years mortgage payments are mostly interest).
There are two popular delutions: one is that all indexes are passive instruments and the seconf that bond funds are the same investment asset class as bonds.
Contrary to the popular wisdom S&P 500 is actually a badly managed stock fund. As Professor Siegel noted in his article Old School Stocks Teach New Lessons The Future for Investors - Yahoo! Finance
"By no means is the S&P 500 Index a static group of firms. On average about 20 new stocks are added to the index each year, and an equal number of firms are removed that merge, go bankrupt, or fall below S&P's standards. Over the nearly 50 year history of the S&P 500 Index, almost one thousand new firms have been added and one thousand old firms deleted. "
Bond funds are not panacea in comparison with stock funds, even taking into account all machination with stock prices. You might benefit from mixing different bond funds (for example junk with TIPS) to diminish volatility
In current circumstances stable value funds can be a blessing.
It is important to understand that bond funds are much complex financial
instrument than bonds themselves because -- unlike the implication in their
name -- they are not really fixed-income investments. Bond
funds do not guarantee the return on your principal after certain number of
years and for intermediate term and long term bond in fact can endanger your
principal even if you hold then substantial number of years. One of the reason
is that bonds in bond fund portfolio constantly rotate. If you try to
withdraw money from the bond fund during the period of Fed tightening you can
lose part of your principal. That's why intermediate and long term bond funds
with returns below 5% (including inflation-protected securities funds -- TIPS)
are very risky to hold and are not safe financial instruments at all. For
junk bonds situation is more complex.
| LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits. LIBOR is used in determining the price of many other financial derivatives, including interest rate futures, swaps and Eurodollars. Due to London's importance as a global financial center, LIBOR applies not only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen and Canadian Dollar. http://www.bankrate.com/brm/ratewatch/other-indices.asp |
As PIMCO Gross notes by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. So fair return for junk bonds is LIBOR + 300 or more. In other words as Gross stresses "for LIBOR+250 high yield lenders are giving away money!"
Money market accounts (stable value funds in 401K terminology) are the most liquid and less dangerous of bond funds and they should probably be integral part of any 401K portfolio, especially in cases where you cannot buy a bond fund that has return above 5%. To sacrifices stability of the stable value fund for just 1% of extra return is extremely stupid. Even with returns above 5% you should gradually displace longer maturity bonds in the portfolio as person ages in the same way as bonds should displace stocks. For the same reason bond indexes are much more questionable idea then stock indexes. Long term high quality bond funds seldom worth either the added risk or the added cost. Treasury Direct might be a simpler and better way to manage your high quality bond port of the portfolio during the retirement as government bonds are tax free.
Investment fees associated with managing bond funds investments (mutual
funds fees) are assessed as a percentage of assets invested, but for bond funds
this is a completely inaccurate method. Bond fund can be considered
partnership between you and bond fund advisors were you provide all the capital
and they provide management. That means that results should be calculated as
a percentage of return after inflation. For example Pimco with its eloquent manager
Bill Gross are taking approximately 0.5% in fees and has return of approximately
4.5%. That means that they are taking 11% of net returns for the management
of funds without even considering inflation. If we are taking about returns
after inflation and assuming inflation to be around 3% a year, they are taking
0.5/1.5=33% of return on your capital and at the same time spending a lot of
your money trying to persuade you that this an extremely good deal.
That's why bonds funds that has returns below 5%
(or Libor rate if you need to be more exact) are generally a bad deal and
you should consider using money market finds instead. I think it is prudent
to avoid buying bonds funds with below 5% returns in 401K portfolio. Please
note that bonds funds fees are not specifically identified on statements, but
can be found in fund prospects and on Yahoo finance. See
A Look At 401(k) Plan Fees for Employees for details.
Bonds are especially vulnerable during "credit crunch" when even A and AA
bonds can be affected (even AAA were affected during Great Depression).
Cutting interest rates during such a crisis (a typical government reaction)
increases inflation that has the effect of transferring wealth from
creditors to debtors. That means transferring wealth away from bond
investors.
From other point of view interest rates are just the price of money.
And low interest rates suggest devalued money and high monetary supply growth.
That is yet another way to explain why bond funds with returns below 5% are
risky to hold. In such cases stable value funds are blessing.
Gold might be blessing too.
And the last but not least: while bond funds fees usually are stated
as the percentage of assets they in reality should be stated as the percentage
of interest earned. That helps to see more realistic picture about who is the
prime beneficiary of the money you put in the fund and how much the second largest
beneficiary share is.
Despite all Wall Street financed PR machine higher risk is not always compensated by higher return. The U.S. stock market is much more risky than most investors perceive it to be and this risk is dramatically higher for short investment periods (let's say periods less then 10 years). Also there was at least one investment period in the USA history when investors who kept their retirement saving (and other savings) in stock lost everything. This period was approximately 100 years from now so there are no survives to tell us how it looks lile. Still we can rely on written memory and that was not pretty picture.
Without anchor in gold for the nation currency, stocks function more like private fiat currencies of particular companies. Even with index funds (baskets of currencies) short term declines can be as big as 30%. There is no guarantee that such drop will not happen during your last years before retirement. If so this is a huge blow. Think about people who retied in late 2002 and have all their money in stocks. Their investment fully recovered only in 2007 -- five years later. Changes that they sold it before are pretty high -- my guestimate they are above 80%. Therefore we can guess that only 20% were left relatively unhurt by explosion of dot-com bubble. And those few are probably exclusively concentrated at the higher end on income, where they can rely on other sources of income to wait for the return of good times.
The idea that buying stock is giving you a share of the wealth of the company is completely unscientific. A lot of corporation have outstanding debt that is either substantial part of their assets or exceed their assets. In a later case company stock formally worth nothing: this is all plain-vanilla confidence game. That means that like in any Ponzi scheme those who cash out early are the only one who get the benefits of playing the game. That might be early boomers as in stocks ownership grossly distorted by 401K plans demographic can play the decisive role (looks at some Senators ramblings about Social Security -- is not that an thinly disguised attempt to find alternative source of buyers for those stocks that will be sold by baby-boomers? ).
Corporate borrowers took advantage of
the low interest-rate environment of the past few years to push stocks
higher by huge buybacks using for that issuance of new bonds.
Some of them
overborrowed during the period of low interest rates. S&P recently
warned that slowing GDP growth could squeeze corporate credit quality, which
is essentially the estimate of the ability to repay debts. The recent
wave of airlines bankruptcies is just one example. Also it is unclear how assets
are valued. Viewing stock as a fiat currency of a particular corporation and
stock market as a giant pool of currency speculators (including you and me) betting on the strength
of different currencies (and sometime manipulating them) to extract a profit
might be a more realistic vision of the current situation then fairy tales
about ownership.
Like in case of currencies the stock market is one of the few marketplaces on
earth where people become more excited to buy when things are expensive, and
more anxious to sell when things are cheap. Moreover there is some evidence
that punch cup of monetary expansion (using money printing press to stimulate
the economy) will be more difficult to serve after Greenspan. Events in 2007
more and more look like a credit crunch. If this is true
there is no guarantee that in ten years' time the US stock market might be
significantly higher than it is now as rise of stock market is a side effect
of huge monetary expansion under Greenspan, expansion which links to the huge extraction
of wealth from former communist countries (dollarization of former Soviet
block). This was a one time historic
event, it is mostly over and some recipients of this largeness are not
happy. Former communist countries were successfully converted
in new Latin America and like in Latin America many countries in the region are
turning more and more anti-American. There is not much that can be done after
that.
Again demographic matters in a sense 401K plans became baby boomers large Ponzi scheme in which only whose who rush to the exit first might preserve wealth. Some experts predict that stock market can stagnate sooner then the major wave of boomer retirements hits the market (2010) as behavior of stock market correlates not only with the state of economy and the pace of monetary expansion but also with the percentage of the population aged 45-55.
| We need to take into account the possibility of a modern variant of a Ponzi scheme ("rob-Peter-to-pay-Paul") in 401K plans for boomers. That might mean that early boomers can get out relatively unhurt, but later folks might have difficulties with offloading "overstocked" portfolios as there might be less demand for stocks from subsequent, numerically weaker, generations and if dollar will continue its slide from foreigners. Of course this is a mere speculation (like any economic prediction) but this might in a significant way to affect your lifestyle after retirement and some prudence is advisable. Excessive greed (aka "appetite for risk") now might hurt your well-being in later years. |
My hypothesis is that by overloading 401K portfolio with stocks, let's say,
percentage-wise above the number dictated by the
(100 - your_age) formula investors
are taking disproportional higher risks why enjoying pretty low chances of sufficient
reward in the form of higher returns. You need to be aware that this is a
just a hypothesis by a non-specialist and treat it with cautions it deserves:
there are just too many gurus who claim to be able to predict the future. Also
economics are a breed which "is often in error but never in doubt" and here I am
wearing an economist hat.
One (weak) heuristic argument in favor
of this hypothesis is that it holds in simulation experiments that I performed
with some stock-bond mixes with holding period of ten years, cost-averaging
contributions for this period (starting from zero capital) and random starting
points in 1990-1996 range. Mixes closer to 50% (even static mixes)
generally behaved better for those periods. And those risks might be even bigger that simulation
on historical data suggests if we take into account financial excesses of both
Clinton and, especially, Bush II administrations (as Dick Cheney quipped
"deficits does not matter"; in a way he was right as real goods
were purchased for fiat currency). Not that other risks are small.
Of course gloomy forecasts like any forecast can be wrong and stocks well can
provide above average returns as they magically started providing in 2003 after
two years of huge losses. Still blindly investing in the mix of stock funds
and assuming that the future is always going to be rosy is a risky strategy.
The closer you are to retirement the less time you have to recover from one
substantial loss due to a sharp stock market decline. As 2001-2002 experience
had shown, no "financial alchemism" (search for "philosophical stone" which magically
turns lead into gold -- a perfect stocks funds mix) fundamentally changes the
risks involved in all stock portfolio.
Economists regard state lotteries as a voluntary, implicit regressive tax. That's because the poor pay a larger proportion of their incomes on lottery or scratch tickets than more prosperous gamblers do. Playing with stock funds in 401K accounts became similar to lotteries for many professionals. Brainwashing by strong "perma-bull sentiment" in the investment banks controlled media outlets suppresses critical thinking. And we all need to remember that it is the financial industry which is paying for this "perma-bull" circus on CNBC and they are only happy to rake in their billions each year, but at what cost to society?
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It is very difficult not to be influenced by the bubblevision, perma-bullish cheerleading for the markets and adopt defensive positions in 401K |
Mutual funds industry has huge influence and associated large sector of financial
media is advocating mostly stocks portfolios (stock mutual funds represent the
dominant share of mutual funds). But without taking into account your age and
market conditions aggressive use of stock funds makes the success of your retirement
plan rests on dumb luck. If you need to retire during significant and prolonged
market slump, you can face a loss of up to a half of your holdings as those
who did this in mid 2002 -- early 2003 discovered. This can be called
"Great American Casino named after Chairman Greenspan". And many otherwise very
reasonable people have natural tendency to gamble with their money in 401K accounts.
In 1999, a National Gambling Impact Study Commission estimated that approximately
5 million of Americans can be classified as "pathological or problem gamblers",
with an additional 15 million at risk. While those probably do not have
401K accounts anyway, with stock funds (like in any casino) not only
"pathological or problem gamblers" are at risk. After all your participation
in 401K is by all accounts a short run -- nobody particulates in it for 50 years.
If we assume that stocks are fiat currencies of private companies and due to complexity of accounting in large corporations it is unclear how financially stable they are and is high P/E ration justified or even if it was calculated correctly, bond funds suffer from other set of problems. Here the main danger is the middleman. Even low cost Vanguard, Fidelity bond funds as well as institutional shares of Pimco funds (or other no load fund families) that are typically present in 401K portfolios probably are adding up to 0.25-0.5% a year in expenses to inflation losses (Pimco institutional Total Return shares have expense ration exactly 0.5%, Vanguard adds less then that).
Whoever has or is given the authority to create credit has the authority to extract wealth from the economy by that same mechanism. The bankers are, in other words, redistributing the wealth of the USA. Thomas Jefferson once noted that "...banking institutions are more dangerous to our liberties than standing armies...". In some aspects bond mutual funds are very close to banks. It is prudent to view economics as an ecosystem, and, as such, it should contain class of economic parasitizes. That means that you are lucky if you preserve your money as some funds (for example Pimco) that have high expenses and substantial share price volatility.
John Fuchs was checking his 401(k) account online one afternoon when he saw something that seemed amiss. Listed along with his regular contributions was a $48 charge, in red. That's odd, he thought. Why would anyone be taking money out of his account?
After a flurry of phone calls and e-mails, Fuchs learned that the $48 deduction was no mistake. The money was paid to an outside firm that enrolls employees in his company's 401(k) plan, mails quarterly account statements and handles other administrative tasks.While $40 a month is rather uncommon (you probably need to have at least $500K in a typical 401K account for this), $10 per month is pretty common. If we assume that account contains only bond funds and the dividend from bond funds is, say, $500 a month, they are deducting additional 2% of dividends each month. This is so called "Plan administration fee". It is unclear why those fees are proportional to the total of your investment as they generally should be fixed on the same level per participant no matter how many money he/she have in the funds. For example those banks who charge feed for maintaining your checking account never change fees based on percentage on your assets.
One of the major factors in "stocks over-consumption" by 401K investors is probably aggressive selling by Wall Street. That can result in adoption (brainwashing or all money of stock 401K investing) or negative reaction that can go to the other extreme (gold bugs and all bond/money market investors). We will discuss the strategies one by one below starting with the so called "Fashionable mix" strategy.
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Last modified: November 15, 2008