Your 401k Investments Are In Big Trouble

Posted on June 14, 2013 at 2:42 PM PST by

Savers often talk about their 401k investments as if they were one big investment: “My 401(k) money,” as if it were a monolithic thing, indivisible and hard to understand.

Investment firms work to make it that way, offering up inscrutable options that sound about the same. Prudent Growth. Balanced Stock. Contra-this and Value-that.

Underlying all of those funds are pretty simplistic mixtures of public company stocks or bonds. And therein lies the rub. You could own 10 different funds and feel well-diversified, but that doesn’t make it so. Five of those funds might have a 10% investment in the same company.

401k investments

A few web sites, among them Morningstar and the private investment industry regulator FINRA, offer online tools to help you understand the 401k investments you’ve bought.  But they can’t help you understand why you own those funds, other than that a plan administrator once briefly mentioned that “diversification” is a good idea.

Diversification doesn’t mean owning more stock or six flavors of indistinguishable mutual funds. It doesn’t even mean owning a smattering of bonds. Diversification means owning a broad mix of asset classes, even things you might not have considered.

As Robert Powell at MarketWatch points out, 401k plans should operate more like pension funds when it comes to available investment classes. Workplace plans, for instance, typically own about 60% stocks and 40% bonds and cash.

Pension funds, meanwhile, play a very different game. A recent breakdown of their holdings showed about 30% stocks, 30% bonds, 2% international bonds, 4.5% real estate and 10% alternative investments, Powell explains.

Whoa, whoa, whoa, you might say. I’m not ready for “alternative” investing. I’m hardly ready for Dow Jones! Yet, you should be thinking more broadly about your 401k investments.

Pension funds didn’t come up with this approach last week. They’ve been steadily investing in a multitude of asset classes for years and years. It’s the same model used by university endowments and major corporations.

It works because pension plans distribute risk across a broader set of possible outcomes. In any given year, one or another investment type is likely to benefit from a short-term wave of attention.

It’s extremely hard to predict what the mass of global investors will chase next. A great pension manager knows that he or she can’t predict these flows and won’t try.

Instead, they build a careful model that balances risk with the time horizon of the investors, then owns the whole market.

401k investments reconsidered

As one side of the teeter-totter rises or falls, it’s a matter of rebalancing, that is, programmatically selling off gainers in order to buy the relative “losers” who get left  behind — for the moment. Decades of finance research shows it works.

Burton Malkiel, the Princeton professor and one of the fathers of passive investing, explains that rebalancing works because it reduces risk while actually increasing returns. It’s the kind of no-brainer approach that 401k investments really need but, too often, simply cannot find in their current plans.