Arguably the most important decision you make when you participate in a 401k plan is how to invest the money you’re contributing to your account. The type of investment portfolio you choose determines the rate at which your account has the potential to grow, therefore determining the income that’ll be available when the time comes to withdraw at retirement age. In this episode of The Agent of Wealth Podcast – the second in a three-part series on 401ks – host Marc Bautis shares some of the biggest mistakes people make at this point in their journey to saving for retirement.
In this episode, you will learn:
- What a target-date fund is.
- The advantages and disadvantages to target-date funds.
- Considerations to make when allocating your 401k.
- How to uncover costs and fees associated with 401k funds.
- And more!
Listen to the first part, Mistakes to Avoid When Contributing to Your 401k.
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. In today’s episode, we’ll talk about mistakes I see people make when allocating investments in their 401k. This is the second part of a three-part series. In the last episode, I discussed mistakes people make when contributing to 401ks, and next, in the final episode, I’ll discuss mistakes people make when taking distributions from 401ks.
In the media, we’re constantly hearing about how the stock market is doing, and with 401ks being many people’s biggest asset, investments made within them – and how well the investments are doing – are a big concern for many. In this episode, I’ll go over a couple of the mistakes I see people make, and these are not in any particular order.
Mistake #1: Contributing to a 401k, But Not Investing the Balance
The first mistake is making contributions to your 401k, but not choosing to invest the money in the account. Years ago, the default investment in a 401k was a money market account. So if you didn’t make an election on how to allocate your 401k, it would basically be cash – sitting there until you did something with it.
Luckily that has changed, I think back in about 2006, with the invention of the target-date fund. A target-date fund is a pre-built portfolio you can invest in, and the name of the target-date fund would have a year as the suffix. You pick the target-date fund closest to the year that you expect to retire. And what happens is, as it gets closer to that year on the target-date fund, your risk position will automatically be adjusted with the theory that as you get closer to retirement, you want to pair down risk.
We’ll talk more about target-date funds in a little. Sometimes these are a great option, sometimes they’re not, but they’re definitely a better option than having the cash sit. But even with automatic enrollments to target-date funds, some people still have funds sitting in cash or in money market accounts in their 401k.
This could be because, at one point, they tried to time the market. We see that a lot now, people don’t like that the stock market is down this year, so they pull their money out of investments, keep it in cash, then forget to reinvest it. This can go on for years.
Sure, maybe you can avoid some of the downturn in a year like this one, but over a long period of time, keeping 401k contributions as cash is not the best way to do it.
Or maybe someone’s contributions are sitting because the money is from an old 401k you lost track of – a 401k from a previous job. It’s important you track down your 401k accounts, keep track of them, and invest within them so the funds don’t sit in cash for a particularly long period of time.
Mistake #2: Allocating 401k Assets Based On Previous Fund Performance
The second mistake I see people make happens when it comes time to allocate your investments. So the way that 401ks usually work is in addition to target-date funds, there’s usually about 20 different fund options you can invest in. You can divvy up your 100% allocation however you want. For example, you can put the whole 100% into one fund. Or you can allocate 20% to five different funds, or so on.
Now, 401k companies are required to provide data a on each fund’s performance over specific periods of time. Usually it’s a year, three years, five years, 10 years, and since the fund’s inception. This is just a percentage. For example, you may see that fund XYZ returned 10% in one year, and fund ABC returned 6% in the same year. This leads people to allocate their assets towards the highest performing funds. If they’re comparing XYZ to ABC with returns of 10% and 6% respectively, they’ll choose XYZ.
Perhaps that fund will produce more returns over time, but the risk in that fund could be too high for the 401k investor. Or maybe that fund just had a good year. Remember, past performance does not indicate future performance.
Mistake #3: Failing to Take Fees Into Account
The next mistake I see people make, also when allocating 401k assets, is forgetting to take fees or expenses of funds into account. There are studies out there that prove that high fee funds with strong performance still don’t pay off in the long run – meaning the fee is not justified.
Now, I’m all for a fee if it is justified, but you want to look at the risk and return of these funds. For example, what are the differences between risks if one is returning 10% and the other is returning 6%?
Mistake #4: Investing in Too Many Funds
Still on the topic of allocating to different funds, another problem is when people see the list of the 20 available fund options, they choose to put a small percentage into each one. These options aren’t intended for that purpose.
You’ll always see a lot more fund options on the equity or stock side than on the bond side, but that doesn’t necessarily mean you should allocate, say, 4% to 25 different funds. I’ve even seen people select multiple target-date funds. By doing that, it’s really hard to tell what investments are in your 401k. Even just looking at the high-level, you should be able to figure out:
- How much is my allocation towards stocks?
- How much is my allocation towards bonds?
When investing in too many funds, it’s almost impossible to tell.
If you’re going to use target-date funds, my recommendation is to make them your only investment: Invest 100% into the target-date fund that is closest to the year that you’re expected to retire.
Mistake #5: Only Considering a Target-Date Fund
While it’s better than not having a 401k investing strategy at all, target-date funds are not always the best option. Here are a couple of potential issues with target-date funds.
The way a target-date fund works is, for example, let’s say you invested in Fidelity Retirement 2045. This would be a target-date fund for anyone expecting to retire close to the year 2045. Within that fund, Fidelity will add multiple funds. They may have Fidelity Magellan Fund, or the Fidelity Total Stock Market Fund, etc. Now, because it’s funds inside of a fund, there’s multiple layers, and therefore multiple fees. So a lot of times, fees for target-date funds are higher than if you just invested directly into the secondary funds (Magellan Fund or Fidelity Total Stock Market Fund) on your own. But, you’d be losing that automatic move target-date funds have.
Another problem with target-date funds is different fund companies allocate investments very differently, even for the same year. For example, let’s say you have the Fidelity 2045 Fund and the Vanguard 2045 Fund. You might think that they have a close allocation to each other, but that’s not necessarily the case. Vanguard may have more international exposure, or Fidelity may have more long-term bond exposure. While you could get lucky, and the one you choose had the perfect allocation strategy for you, it’s best to know what you’re getting into.
When someone comes to us for help in determining their asset allocation, we ask for the list of the options within their 401k and we do a comparison. We’ll look at their risk return profile and then use software that comes up with an optimal allocation strategy within all of their options available. We look at how to diversify risk, what the highest projected return is, and we’ll tell them our findings.
In some cases, the target-date fund has stronger projections than the optimal allocation they can make with the other options. And in some cases they can make a better allocation by individually selecting funds, versus going with a target-date fund. So it’s important to consider all of your options.
Mistake #6: Investing Too Conservatively, or Too Aggressively
Another mistake I see people make is they invest either too conservatively or too aggressively.
If we take this year as an example, the S&P is down about 15%. But people aren’t buying more stock, even though the prices are cheaper. A study from Allianz Life found that just one in four Americans say it’s a good time to invest in the stock market, and 65% say they’re keeping more money than they should out of the market out of fear of investment losses. My recommendation here is that if you’re making contributions to your 401k during every pay period, keep it going, because there’s something called dollar cost averaging that helps you in market downturns.
Here’s an example to illustrate this: Let’s say your 401k contribution every pay period is $1,000. Let’s say you’re putting that $1,000 into one fund who’s price per share is $100. If you put in $1,000 and the price per share is 100, you can buy 10 shares of fund XYZ. But prices for fund XYZ go down, so now it’s priced at $90 a share. Now, the next time you allocate money toward your 401k, the same $1,000 can buy 11.11 shares of fund XYZ, versus 10. This changes your average price per share to about $95 a share. So you’re able to lower the average price that you have, and then when the recovery comes, your price per share will be lower, therefore you’ll have more shares. Your gains will have improved.
On the contrary, I do see people who are too aggressive with their 401k. You really want to match your allocation with how much risk you need to hit your goals. For a 401k, most people’s goal is to have a pool of assets to draw down in retirement… and to prevent running out of that money.
I speak with a lot of people whose goal is just to beat the S&P 500. And I’m all for competition, benchmarking and measuring, but a lot of times this goal doesn’t make sense. It’s just too aggressive, especially as you approach retirement age.
When people are too aggressive and there is a drop in the market, their emotions take over and they can make an irrational decision with their 401k, like withdrawing their investments and keeping the money in their 401k on the sidelines. Fidelity did a study that found that the most successful 401k investors were ones that lost the password to their online account. It may sound like a joke, but it wasn’t.
Richard Bernstein Advisors ran an analysis of 20 years of investing data and came to the conclusion that the average investor underperformed every asset category from 1993 to 2013, with the exception of Asian Emerging Markets. This data included underperforming cash, which was represented by three month T bills. You may say, “Well, how can they actually underperform cash if the worst they can do is sit on it?” It’s because that natural behavior is to be really confident when the market is going up and then be fearful when the market is going down.
Mistake #7: Buying the S&P 500 Index In Your 401k
The final mistake I’ll cover today is buying the S&P 500 Index in your 401k. Some people say, “You know what? I’m a believer in US large cap stocks. I don’t need fixed income, I don’t need smaller mid caps or any international stocks.” While this has worked out great over the past 5-10 years, I always point back to the years 2000-2009, which is called the lost decade because the S&P 500 started higher than it finished after 10 years.
There are countless studies on why diversification works, from both the perspective of trying to smooth out your returns, but also of trying to avoid emotional investing.
And then there’s fixed income. People have said to me, “I never want to touch a bond.” Bonds used to be added to portfolios for hedging and for diversification. If the stock market is down, a lot of people would put money into bonds and therefore the bond price would go up and it would hedge a little bit, or like I said, smooth out that return. But what’s happened over the past year with interest rates rising, the interest in some bonds that they’re providing, it can be acceptable to some investors, especially as you’re getting closer to retirement and you’re looking for income in the portfolio.
While I always say you should talk to a financial professional before making decisions, fixed income may be something you take a deeper look at now.
So, we covered some of the major mistakes I see people make that can trip up their 401k investments and sabotage their retirement. We all want to go in managing our 401k with the best intention, but sometimes our emotions or what we hear in the media can get in the way of achieving our goals.
If you’d like to see if you can make any improvements on how you’re managing your 401k, you can schedule a call with me below. Thanks for tuning into today’s episode.