Sinkorswim

09/28/03 - When It Comes To 401(k) Choices Less Is More Part II

By: Investor Solutions, Inc.

Don't be a victim of your 401(k) plan!

Depending on how clever your boss is you may have 10 great mutual funds in your plan or 100 lousy choices. Your fund costs could be reasonable or they may be exorbitant. In part of one of this two part series, we discussed the need for employers to streamline investment choices in corporate retirement plans. This segment I will show you how to work within the confines of your plan to construct a better portfolio.

Two generations ago, pensions and social security ensured a secure retirement for our grandparents. Today, the virtual extinction of pension plans has shifted the burden of retirement savings away from corporations and onto the employees. Our retirement depends largely on our own ability to save and invest wisely. And while you have been forced to take on more risk to secure your future, you have not been given the tools needed to make informed decisions.

Nobody cares about your money more than you. So, to improve your 401k accounts and increase the probability of a successful retirement, follow these simple steps.

Step 1: Education

When it comes to money, ignorance is not bliss. If your employer's retirement education is nonexistent or inadequate (and they usually are), teach yourself. Investing is a science, not a random game of chance. Unlike the roulette table, there's more to investing than just placing your chips on a green felt table. Employing a rational, scientific approach to portfolio construction will increase your bottom line in the long run.

Get acquainted with basic financial concepts and your chances of success should improve dramatically. Education = power = better decisions.

Step 2: Minimize Costs

In an ideal world, plans would be forced to:

• Reveal their annual expenses to participants in dollar terms, not expense ratios.
• Provide adequate and regular participant investment education
• Limit choices to high quality, low cost index funds for global diversification

In reality, participants often give up more than 2% per year in returns to cover fund expenses and they don't even know it! Compare that to a cost of less than 0.25% for an index fund. For every dollar you save on expenses or administrative costs, that's an extra dollar (plus compounding) in your nest egg. According to the Department of Labor, fees can diminish your lifetime 401k accumulations by as much as 30%.

Let's put this statistic to the test. After 30 years worth of saving $500 a month into a plan, a participant with a rate of return of 8% over the period will have accumulated $745,179. Using the same scenario, but factoring in 2% of fund fees will only generate $502,257; that's a 32% reduction. Lesson learned: every penny counts!

Study your choices and look for funds with the lowest expense ratios that fit into your overall investment strategy If you're regrettably stuck with a plan with poor choices or are paying over 1.5% in fund fees, bring it to management's attention! They may be in violation of their fiduciary responsibility to act in your best interest. Some plans may be offer such lousy choices or be so expensive; it may not even be worth participating in the plan.

Step 3: Diversify Investments

The worst disasters for small investors can almost always be traced to the same source: a lack of diversification. How much you allocate between stocks, bonds, and cash has a greater impact on your bottom line than your actual investment choices In fact, your asset allocation drives 94% of your portfolio's investment returns.

Diversification across different styles will greatly reduce your portfolio risk and maximize return. Our firm uses the following asset classes: Large, Large Value, Small, Small Value, International Large, International Large Value, International Small, International Small Value, Emerging Markets and Short Term Bonds. Employing these asset classes in your account will result in true global diversification and tilting toward small and value should enhance returns over time.

Also, holding large concentrations of any one investment or asset class (including company stock) will dramatically increase your portfolio risk, minimizing your chances of success.

Avoid investment overlap and don't buy two funds that have similar characteristics. For example, if you already own an S&P 500 fund in your account, buying the Fidelity Growth fund won't offer much additional diversification since both represent large domestic companies. Consider instead (or as part of your portfolio) allocating to small value, large value, small growth and international.

Portfolios should be constructed based on personal risk tolerance, time horizon and cash flow requirements. For example, younger participants will likely to have different portfolios than the older participants that are nearing retirement. . Risk adverse investors or pre-retirees should also temper their portfolio risk by adding short-term bond funds to their account to dampen volatility. If in addition to your corporate retirement plan you hold investments outside, it's important to account for those positions when determining investment policy in your plan.

Step 4: Avoid Market Timing

Incessant tinkering with your portfolio is a losing strategy. Investors are misguided in thinking that past performance is somehow an indication of future potential. Not true!

Attempting to chase yesterday's returns is an easy way to consistently lose. Maintaining a long-term strategy and sticking to it will vastly improve the ability to grow your account.

Step 5: Rebalance Annually

Annual rebalancing offers a systematic way of restoring your allocation to its original target percentages. Market movements (whether up or down) will create deviations from your original allocation. A happy byproduct of regular rebalancing forces investors to "buy low and sell high".

Vanguard has found that nearly 85% of investors participating in their retirement plans never trade. And while we're not advocating constantly tinkering with your portfolio, a successful outcome greatly depends on sticking to your investment targets.

For example, if your objective is to hold 20% of the S&P 500 and subsequent market growth has increased your exposure to 35%, you are way off target. The result may be a highly concentrated portfolio and an increased portfolio risk. What you do to correct this is sell enough of the position to revert to your 20% allocation and buy into asset classes that may be under your target percentage. Restoring your portfolio to its original asset class targets will not only instill stability but also ensure you remain diversified.

In summary, your investments are your future and making mistakes in your 401k can be frighteningly easy. Don't be a casualty of your retirement plan. If participants only knew how much money they were throwing away each year in fees, they would demand better plans from their bosses. If you're unhappy about your choices, speak up and demand change! Employers have a fiduciary obligation to act in your best interest and that means better choices.

By following these simple steps (education, cost minimization, diversification and regular rebalancing), you are on your way to securing a stable retirement; the rest is now up to the markets.

Some great resources to check out:

The Informed Investor, by Frank Armstrong

Capital Ideas by Peter Bernstein

Investment Strategies for the 21st Century (free online) at http://www.InvestorSolutions.com

The Vanguard Website http://www.vanguard.com

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