THE PRUDENT OPINION
Risk and Your 401 K Plan – How to Invest your Retirement Money
Since I started in the investment business in 1992, I have always been fascinated by the subject of risk. I am fascinated by the psychology of risk and how investors view risk. At the same time, risk is a highly technical, complicated study. The good news is that you don’t have to be a scholar to understand the basics. By understanding the basics, you can dramatically make a big difference in the ultimate outcome of your investments.
There are 3 basic points that will help you understand risk:
(The following is intended for educational purposes only and not offered as advice of any kind. Before making any changes to your current portfolio, please consult with a professional.)
- The Bad Years Greatly Outweigh the Good Years
I would bet that most stock market investors have a fairly confident feeling after the past 4 years. Unfortunately, if history is any guide, then there is a high probability that we have a significant decline ahead of us. Based on all types of studies we could be looking at anywhere between a 30% to 40% decline in the stock market. Of course, we could also skate by with a small correction. My point is that it is important to respect what history says and heed the warnings.
Let’s take the example of Bill. Bill had a rough time in the bear market between 2000 and 2002. In 2000, he had $100,000. Just 2 years later, his $100,000 had been reduced to $62,000. Fortunately, over the next 4 years, his account climbed all of the way to $105,000. Feeling better, he wasn’t really paying to much attention to his portfolio.
Now, if a bear market were to hit, his account could fall to between $73,000 and
$63,000 if history was used as a guide. His account is 100% invested in the stock market.
It would take a return of 43% to 66% to just get back to pre-bear market levels.
In a short time period, a Bear Market can destroy 3 to 4 years of investment growth. Contrary to what the 9 trillion dollar financial services business wants you to believe, things are not different and bear markets do happen.
- Time plus Loss equals Risk
Most investors think of risk solely in terms of loss. What is the risk of losing money in an investment? You also have to factor in time. Regardless of your timeframe, I don’t think that anyone whether they are 25 or 65 should be heavily invested in the stock market when the risk meters are off the chart. However, if you are within 3 to 5 years of needing your money, you cannot afford to put yourself in a position where you could potentially lose a great deal of your investment account.
- Quantity does not equal Diversification
This is the most important of the three to understand. It is also something that you can apply to your 401(k) plan. Investors will confuse a 401(k) account with 9 different mutual funds as a diversified portfolio. Unfortunately, that is not always the case. Typically those 9 mutual funds are all stock funds. Thus, there is no diversification when 100% is invested in stocks. Diversification is not about quantity. It is about quantity and type of investments.
(4) There are two main types of investments – Stocks and Fixed Investments
When looking at your 401(k) plan, think of it as how much do you have invested in a stock and how much do you have invested in a fixed investment? Unfortunately in a 401(k) plan, that is usually the only two types of investments offered.
The stock category would include everything that is a stock. That could be international, real estate stocks, gold stocks, large company stocks, medium company stocks, or small company stocks. As we saw during that big decline a few weeks ago, EVERYTHING that was stock-related lost big. Although there were certain types of stocks that made money in the last bear market, I don’t think that you are going to see that occur this time around.
Fixed investments are investments such as money markets, CDs, bonds, stable value funds, etc. These are lower risk investments.
The Combination of stocks and fixed investments can make an enormous difference.
I put together a research study in 2006 that looked at the risk levels of various combinations of stocks and fixed investments.
1975 to 2005 Risk and Reward Study |
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% in Stock |
10% |
20% |
40% |
50% |
70% |
80% |
90% |
% in Fixed Investments |
90% |
80% |
60% |
50% |
30% |
20% |
10% |
|
|
|
|
|
|
|
|
Average Annual Return |
7.72% |
8.45% |
9.69% |
10.18% |
11.29% |
11.73% |
12.23% |
Number of Positive Years |
30 |
29 |
27 |
26 |
26 |
24 |
24 |
Number of Negative Years |
0 |
1 |
3 |
4 |
4 |
6 |
6 |
Worst Loss in a Year |
|
-0.25% |
-5.56% |
-8.52% |
-13.83% |
-16.79% |
-19.45% |
Best Gain in a Year |
18.52% |
19.54% |
20.99% |
23.54% |
29.29% |
31.83% |
34.71% |
2000 to 2002 Total Return |
11.96% |
6.24% |
-5.84% |
-12.10% |
-22.77% |
-28.28% |
-33.05% |
2003 to 2005 Total Return |
9.39% |
13.59% |
22.17% |
26.54% |
35.57% |
40.17% |
44.88% |
Thomson Financial
Prudent Money Financial Services 2006
As you can see, you take on more risk as you add more stock to your 401(k) account. Over that 30-year period, a 10% stock and 90% fixed income portfolio never lost money. However a 90% stock and a 10% fixed income had 6 losing years. A portfolio that has 50% in stocks and 50% in fixed income only had 4 losing years. You can also see the big difference between biggest one year returns.
Likewise, you can also see a big difference in the worst loss for a year. The numbers that reveal the most about risk are found during the 2000 and 2002 bear market years. You go from a range of 11.96% gain to a -33.05% loss. That is a big difference.
So How Do I apply this to my 401(k) plan?
Taking the above chart into consideration, pretend you have a risk dial at your disposal. If you want to take on more risk, turn up the dial by increasing the stock exposure and reducing the fixed investments in your 401(k) plan. If you want to decrease your risk, decrease the stocks in your 401(k) plan and increase the fixed investments.
This is a simplistic way to look at constructing a portfolio in a 401(k) plan. However, at the minimum, it does give you a framework for making decisions.
How do I get started?
First, look at all of your investment choices and divide them between stocks and fixed investments. There should be plenty of material that helps you accomplish this division. You can also call the investment companies if you are unsure.
Second, assess your risk appetite. This is a tough one because risk is unique to your own situation. Just look at the growth in your account over the past 3 or 4 years and determine if you want to risk it. There is a time to turn down the risk dial. Assess your time frame and when you might need the investments.
When assessing your risk level it is tough to know when to put on the brakes or hit the gas. However, keep this one thing in mind. If you have a portfolio that is 100% in stocks without any diversification to help offset declines in the market, then consider having an exit strategy. An exit strategy is very important to have in place. In my opinion, that is a great deal of risk exposure.
How the portfolio in the study was allocated
(For those who want to get deeper into the subject of diversification)
1975 to 2005 Risk and Reward Study |
|||||||
% in Stock |
10% |
20% |
40% |
50% |
70% |
80% |
90% |
% in Fixed Investments |
90% |
80% |
60% |
50% |
30% |
20% |
10% |
|
|
|
|
|
|
|
|
Average Annual Return |
7.72% |
8.45% |
9.69% |
10.18% |
11.29% |
11.73% |
12.23% |
Number of Positive Years |
30 |
29 |
27 |
26 |
26 |
24 |
24 |
Number of Negative Years |
0 |
1 |
3 |
4 |
4 |
6 |
6 |
Worst Loss in a Year |
|
-0.25% |
-5.56% |
-8.52% |
-13.83% |
-16.79% |
-19.45% |
Best Gain in a Year |
18.52% |
19.54% |
20.99% |
23.54% |
29.29% |
31.83% |
34.71% |
2000 to 2002 Total Return |
11.96% |
6.24% |
-5.84% |
-12.10% |
-22.77% |
-28.28% |
-33.05% |
2003 to 2005 Total Return |
9.39% |
13.59% |
22.17% |
26.54% |
35.57% |
40.17% |
44.88% |
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|
|
|
|
|
|
Portfolio Allocations |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
30 Day Money Market |
20.0% |
15.0% |
10.0% |
10.0% |
5.0% |
5.0% |
2.5% |
Lehman Bro1-5-Yr Gov’t Bond |
50.0% |
50.0% |
40.0% |
30.0% |
20.0% |
10.0% |
5.0% |
S&P 500 Comp Total Return |
10.0% |
20.0% |
40.0% |
50.0% |
70.0% |
80.0% |
90.0% |
T-Bill - 3 Month Yield |
20.0% |
15.0% |
10.0% |
10.0% |
5.0% |
5.0% |
2.5% |
Thomson Financial
Prudent Money Financial Services 2006
The stock allocation was represented by the S&P 500 composite total return. There wasn’t much diversification. You could easily take that portion and divide it amongst the following classifications of stocks:
Large Company Value and Growth
Medium Company Value and Growth
Small Company Value and Growth
International Stocks
Real Estate Stocks
Commodity Stocks
That is not an exhaustive list by any means. However, that covers most of the main categories.
The fixed income section was represented by short-term and medium term bonds. You could take that portion of the portfolio and divide it amongst the following classifications of fixed income:
Short-term Government Bonds
Intermediate-term Government Bonds
Long-term Government Bonds
Money Market Rates
CDs
Corporate Bonds
High Yield Bonds
Municipal Bonds (not a good choice for a 401(k) plan – more appropriate for after tax accounts)
International Bonds
Once again, this is not an exhaustive list by any means. However, that covers most of the main categories.
BE CAREFUL BONDS ARE NOT ALWAYS A SAFE HAVEN
You can have years where stocks and bonds both lose money. Dating back to 1950, this occurred in 1957, 1969, 1973, and 1974. In those years, a simple money market would have been the best bet for the fixed portion of the portfolio. When money market rates are higher, it makes more sense to consider using them as a heavier percentage of your fixed income portfolio.