401(k) Investors Must Avoid Stock Market Noise

Posted on March 11, 2013 at 9:30 AM PST by

If you talk to engineers or scientists, you’ll eventually hear about “signal-to-noise ratio.” It’s an interesting concept, one with implications for 401(k) investors who believe that they can pick stocks amid stock market noise.

First, let’s talk signal-to-noise. Remember old-fashioned car radios? As you turned the dial, you often heard fuzzy sounds on either side of the stronger stations. That’s signal fighting through noise.

radio

Digital communication does away with that problem, so music now tends to seem “perfect” to the casual listener.

Yes, you give up fidelity — some highs and lows you used to hear — when you use digital music formats, but the absence of noise is impressive. It’s slightly less signal but virtually zero noise.

Financial markets are all noise. You know that. But for 401(k) investors the sources of stock market noise can be unexpected or worse, completely unrecognized.

For instance, 401(k) investors are limited, in most plans, to a selection of mutual funds. They pay extraordinarily high fees for those funds, often without realizing it, and must accept the returns of managers selected by the plan administrator.

Many plans also allow 401(k) investors to own company stock within the plan. This is perceived as a benefit, since the stock is granted as compensation or sold at a steep discount to current pricing.

As a result, 401(k) investors find themselves hobbled with concentrated holdings. The employee’s perception of risk is distorted by a single-company anchor position, one which is rarely sold and often treated as a permanent investment, regardless of the company’s prospects or value.

Familiarity breeds comfort, so employees load up on even more risk elsewhere in the portfolio.

Beyond that problem, plan administrators chase performance, according to a paper from the Center for Retirement Research at Boston College.

The researchers studied a sample of 43 plans with average assets of $310 million, following them from the years 1994 to 1999.

They found that 401(k) plan administrators underperformed their benchmarks by 31 basis points compared to passive index funds. That’s a pretty big problem all by itself. Why do even have these jobs, one might wonder?

Compared to a random selection of comparable active funds, plan administrators’ choices outperformed by 52 basis points, yet nearly half of the relative gain (23 basis points) is explained by their own choice to use cheaper funds.

Secondly, when administrators try to chase performance, that is, to change from lower-performing funds to higher, it backfires. More stock market noise ensues.

They tended to choose funds that had done better than their previous holdings (277 basis points better, about half on relative gains and half because the previous funds declined in comparison).

Which pretty much means only that they can read a results table (100% past performance) and choose the clear winners. A middle-school student could do the same and would charge you less.

Nevertheless, immediately after choosing the new funds, outperformance fell to a statistical dead heat, with the “hot” funds now essentially matching the performance of the “dog” funds that got dropped.

That’s a lot of stock market noise so far: Problems with administrators who chase performance, problems with overweighted, unbalanced portfolios.

But what about the individual investors? The researchers concluded that 401(k) investors also tended to chase performance and engage in unbalanced strategies that cost them money.

In short, 401(k) investors did as well buying all of the funds available to them in equal measure, what researchers non-judgmentally call a “naive strategy,” over picking funds for whatever reason.

Add on top of that the perception among some 401(k) investors that they can “self direct” a company-sponsored 401(k) plan at the macroeconomic level.

Given the level of stock market noise, the idea of being able to “guess right” the direction of a given asset class quickly becomes preposterous. It’s extremely hard to do that with individual investment holdings and unrestricted trading ability — features most 401(k) retirement plans and mutual funds do not offer for good reason.

Even if you could do it, chances are high that they result would be poor. JPMorgan Chase notes that a whopping 63% of active managers are losing against their benchmarks, and just 7 percent are beating by more than 2.5%.

Stock market noise vs. investors

To correctly manage a retirement, 401(k) investors must deal with a variety of noisy obstacles. Active fund managers, active administrators, their own macro trading biases and a mountain of fees attached at virtually every turn.

Think about that next you consider changing up your 401(k) investments on the fly in preparation for the markets to come.

How much stock market noise are you fighting in an attempt to hear the signal? Do you hear it at all, under the layers of fund managers and fund admins, each running on their own biases and misperceptions?

If you don’t know (and you don’t, really), you’re much better off owning an allocated portfolio of index funds and ETFs, plain and simple.

Controlling what you can control is the name of the game, and cost is the single biggest factor that you should seek to rein in, either by picking passive funds or, if they are missing from your plan, by asking your plan administrator to provide them, pronto.

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