Seeking Immediate Gains From a 401(k) is Shortsighted
Long -Term Strategies for Retirement Investing
Reprinted with the permission of the San Diego Business Journal – excerpt from article printed April 16, 2001
By – J. Graydon Coghlan – Coghlan Financial Group, Inc.
When you review your returns on the investments in your 401(k) plan, you may be disappointed if you don’t see the kind of double-digit gains that some investments in the stock market have been returning over the past few years. You might be wishing your employer would add investment choices representing market sectors such as technology or health care. You’re not alone. Recently the Hartford, Conn.-based Spectrem Group, polled about 400 participants in employer-sponsored 401(k) retirement plans.
Telephone interviews were conducted in February with a nationally representative sample of 402 participants in 401(k) plans. The average age of respondents was 45. All of them had household incomes of $75,000 or greater and 65 percent were college educated. Median plan assets were $60,000 and 75 percent of respondents had been participating in a plan for more than five years. Many participants expressed interest in having certain types of investment choices made available to them, particularly in fund categories that have been performing well in recent months: technology and other sector funds, large cap funds and broad market indexes. The desire to chase the latest hot performers is understandable, but it may not be the best strategy, particularly for retirement investing. Attempting to catch investments at just the right time is a short-term strategy that can jeopardize your returns over time. The market’s performance over the past few years has turned 401(k) participants into fairly active investors – half of the respondents in (the) survey said they had reviewed their asset allocation mix in the past month, and 25 percent said they reviewed their investments once a month or more. More than half said they had made a change in their investment allocation in the past year.
While plan participants may be actively involved in making their own investment decisions, they may not be making choices consistent with the long-term nature of retirement investing. Plan participants were most interested in adding fund types that have had strong short term performance and publicity: sector funds (37 percent) and sector index funds (18 percent), large cap funds (23 percent) and broad market indexes (21 percent). And, changes in investment selections were most often made in reactions to market conditions – no more than 20 percent of participants said they made changes as a result of plan information or advisor recommendations. Expectations have also clearly been conditioned by recent investment experience. Over the next five years, seven out of 10 respondents said they expected their account returns to equal or exceed their 1999 returns, which they reported averaged 21 percent.
Reality Vs. Expectations
These expectations for continued high returns may be unrealistic. It’s true that during the last five years, US stocks as measured by the S&P 500 composite index have returned an average of 28.16 percent. Over the last 10 years, however, the average annual return has been a lower 18.25 percent, according to the Frank Russell Co., which provides financial planning for individuals and institutions around the world. When you consider an even longer period of time, returns drop even more – over the last 80 years the average annual return has been 13.09 percent.
Average annual returns for the time periods noted are based on the Standard & Poor’s 500 composite stock index, [An unmanaged index considered to be representative of the stock market in general. An investment may not be made directly in an index. Past performance is not a guarantee of future results], with dividends reinvested. When you’re tempted to jump into an investment that’s currently hot – whether stocks, bonds or cash – consider this: Attempts to time the market can be disastrous. Take a $1 investment made in the stock market over a 20-year time period from 1978 to 1998. That $1, if invested in stocks, would be worth $26.24 after 20 years, according to calculations by Ibboston Associates, Inc. But if your hypothetical investor missed the best 15 months of trading while jumping in and out of the market, that $1 investment would be worth just $6.67. If the same illustration is stretched out to represent the market from 1925 to 1998, a $1 investment in the broad stock market would be worth $2,351. But if our investor missed the best 40 months of trading, the $1 investment would be worth just $14.10. In fact, if the investor had stayed out of the market altogether and invested only in cash and cash equivalents like money market funds, he or she would have made out better, holding an investment worth $14.94. Those calculations assume reinvestment of income and no transaction costs or taxes. Returns are based on indexes and are illustrative.
Size Up Your Expectations
Increasingly, 401(k) plans are a major part of many Americans’ plans for the future. On average, respondents in our survey held close to half their households’ investable assets in their 401(k) accounts. In a survey last year, the Employee Benefit Research Institute found that the average 401(k) account balance was over $37,000 – an average that rose to more than $87,000 for older plan participants.
To avoid having unreasonable expectations of a 401(k) plan, you should remain focused on long-term asset allocation strategies. If your plan has a broad selection of funds, you can establish and maintain a well-conceived asset allocation strategy that suits individual investment goals and time frames, and risk tolerance. While holding a mix of stocks, bonds and cash may not sound as exciting as chasing the latest hot stocks, it can be more rewarding over the long term. Having a diversified portfolio can cushion the effects of market volatility and enhance total returns. Balancing the stock portion of a portfolio between stocks of deferent types, such as small and large capitalization stocks or domestic and international stocks, is a part of diversification.
Simply by participating in a 401(k) plan, you can also take advantage of another proven investing strategy, that of dollar cost averaging. By investing the same dollar amount on a periodic basis in the same security, as you do in a 401(k) plan, you automatically buy more shares when prices are down and fewer shares when prices are high. Over time, you may be able to lower your average cost per share, which can boost your overall investment returns. Dollar cost averaging cannot guarantee a profit or protect against losses. Your 401(k) may be a major factor in your retirement planning, talk with a financial consultant about how to invest a way that may help you reach retirement goals.