If you’re lucky enough that your employer provides a 401(k) plan, you’ve had that the experience of sitting down with a list of investment funds that your plan provider makes available to you and deciding where to put your money. Stocks? Small-cap, mid-cap, or large-cap? Or maybe exotic foreign stocks? Bonds maybe? Short-term, intermediate-term, or high-yield? Heck maybe even money market.
How to decide? There is a handy “annualized performance” section which displays the return for the various funds, with columns for year-to-date, 1 year, 3 years, 5 years, and since the fund’s inception. Why not pick the one with the highest return since inception and put all your eggs in that basket? But there is an asterisk:
Past performance is no guarantee of future results.
That’s the bummer mantra of investment literature. Gangbuster performance in the past doesn’t mean the investment won’t fall on its face tomorrow. So maybe spread the eggs around. The program literature might have a handy guide to follow, broken up by age group and how aggressive you’d like to be with your investments. Do you want to be aggressive and you are between 20 and 40 years of age? Looks like putting 90-100% into stocks and 0-10% into bonds is for you. Hmm…but what kind of stocks? Also, there is another asterisk:
These allocations are only suggestions. The proper asset allocation for your situation may differ. Your final decision on asset allocation should be based on your individual situation, needs, goals, and aversion to risk.
Ok, but if my goal is to retire in the south of France, and my aversion to risk is intense, what asset allocation does that translate to? The literature doesn’t say. Would more education, more financial literacy help? Maybe some…at least then you’d know the different between a stock and a bond, but it’s hard to see how that would provide much help in actually deciding how to invest.
Besides, it’s far from clear that the professionals are any better at investing than us amateurs. Hedge funds go belly up all the time. Mutual funds often fail to outperform the market, especially in the long term, and especially when you include the fees paid to the professionals who manage the funds. (Oh, the fees! A cynic might think that those fees have more to do with the drive for the privatization of Social Security than humanitarian concern for retirees)
The Wall Street Journal has been holding a dartboard contest for a while, where a portfolio of darts thrown at a stock table are compared with professional picks. The results haven’t been great for the professionals, particularly when taking risk into account. In his book Extreme Money, Satyajit Das quotes a famous financier and investor:
If you are ready and able to give up everything else, to study the whole history and background of the market and all the principal companies whose stocks are on the board as carefully as a medical student studies anatomy, to glue your nose to the tape at the opening of every day of the year and never take it off till night; if you can do all that and in addition you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a chance.
I’m not convinced it’s that hard to invest successfully, but clearly, and shockingly, the vast majority of people aren’t good at predicting the future. They don’t have crystal balls. And needing a crystal ball extends beyond figuring out what stock or mutual fund to pick, it includes questions about how long we’ll live, what inflation will be, what interest rates will be, and how much we’ll need for healthcare expenses. And not knowing the future can be a liability when it comes to figuring out retirement.
Because, as Thomas Friedman put it in his own, special, way, it’s a 401(k) world. We’ve moved away from a defined benefit retirement system to a defined contribution system. The defined benefit plan is the old pension system, you work for a company for 30 years, retire, get a gold watch, and get a guaranteed portion of your salary for the rest of your life. The company handles making sure that there will be enough money in the pool to pay all of its retired workers. With the defined contribution plan, like a 401(k), you are guaranteed to invest what you like, but what you get out…well…who knows? If the stock market doesn’t crash it might be a good chunk of change. Good thing stock markets hardly ever crash. The management burden, and investment risks, are shifted to the worker, as a recent episode of Frontline titled The Retirement Gamble compellingly discusses.
Oh, and the fees. There is the percentage point, or points, that are taken by the professionals who manage the funds. As Frontline showed, these points translate to huge amounts over time, carving surprising chunks out of your retirement nest egg. But fees don’t stop there. One thing I’d been curious about, looking at the funds available in my 401(k) plan, is how those specific funds are chosen. Why say, a certain Fidelity fund rather than one of the thousands of other funds out there? Frontline doesn’t go into much detail on this point, but it involved kickbacks from the fund to the manager of the retirement plan. And not surprisingly, the cost of those kickbacks are paid for by the employee, the investor in the plan. Not surprisingly, this is a pretty opaque area, good luck finding information about it in your plan literature.
So what is someone without a crystal ball to do? John Bogle’s advice seems reasonable: invest in low cost funds that aren’t actively managed but simply track a basic stock index, such as the DOW or S&P 500. And hope the stock market doesn’t go belly up. At the very least you can have the satisfaction that a huge portion of your retirement investing isn’t going to lining the pockets of financial “professionals”.