Here is a conversation I’ve had too many times: An acquaintance says proudly that he invests the maximum into his 401(k). I ask what allocation he’s made between equities and bonds. He says he just divides his contributions equally among the four investment choices the plan offers. I cringe.
While it’s wise to put the maximum into your 401(k), it’s also important to choose the right investment options. This is difficult for most people, as shown in the 2004 book, Pension Design and Structure, by Olivia Mitchell and Stephen Utkus.
In one study, participants were asked to allocate their 401(k) contributions between two investment funds. The first group was given a choice of a bond fund and a stock fund. A second group was given the choice of a bond fund and a balanced fund (50% in stocks and 50% in bonds). A third group was given the choice of a stock fund and a balanced fund.
In all three cases, a common strategy was for participants to split their contributions equally between the two funds offered. Yet because of the difference in the funds, the asset allocations of each group differed radically. The average allocation to stocks was 54% for the first group, 35% for the second, and 73% for the third.
In another experiment, participants were asked to select investments from three different menus offering options with varying degrees of risk. Most made their choices simply by avoiding both the high-risk and the low-risk extremes. They didn’t select a portfolio from the available options based on the appropriateness of the risk each presented.
Investing your retirement funds in such a haphazard manner is almost the same as playing the roulette wheel. A portfolio with 35% in stocks will perform very differently than one with 73%. Especially if you’re young, holding the portfolio with the 35% stock allocation or the 73% may mean a significant difference in your retirement lifestyle.
In another study, when employees were given a choice between holding their own portfolio or that of the average participant in the plan, about 80% chose the average portfolio. That’s like going into a clothing store and telling the sales clerk, “Just give me a suit in whatever size you sell the most.”
These studies suggest ways employers can help employees make better investment decisions. One strategy is to reduce their investment choices to a small number of funds that offer portfolios with an asset allocation based on various target retirement dates. Another is to offer employees a variety of investment choices, along with guidance and education so they could make intelligent choices.
In my 30 years of investment experience, the strategy I’ve seen work the best is having a wide variety of asset classes (global stocks, global bonds, treasury inflation protected securities, real estate investment trusts, and commodities) that do well in a variety of economic scenarios. A study reported on by Peng Chen in Financial Planning in 2010 found that from 1970 to 2009, a portfolio with a minimum of 10% to a maximum of 30% in each of these asset classes out-performed portfolios that did not have commodity exposure. Splitting 401(k) contributions equally among these asset classes would provide a greater chance of having an appropriately well-balanced portfolio.
Once you’ve chosen a variety of asset classes, then keep your hands off except for periodic rebalancing. True, this strategy means that in any given year your portfolio will always have winners and losers. Yet with a broad range of assets, the losers and winners tend to balance out. Over the long run the odds are good that you will do fine.
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What Investors Want to Know but Don’t Know How to Ask
Dare to Be Boring: Invest, Don’t Speculate
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