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When it comes to a diversified portfolio, how many funds is the optimal number? Well, it kinda depends on each case, but I'm gonna go out on a limb here and say that 19 separate funds is way too many. That's the situation facing Jennifer from Buffalo.
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"Jill on Money" theme music is by Joel Goodman, www.joelgoodman.com.
Some retirement mistakes are out of our control. For example, you may decide to call it quits amid a terrible recession, which can upend all of the best calculations in the world. But there are plenty of missteps that we can easily avoid, with just a bit of attention and planning. Here are my top 5 Retirement Plan Mistakes to Avoid. 1. Withdrawing instead of Rolling Over: During the recession, many were forced to take withdrawals from their retirement accounts to survive. Unfortunately, there are still too many workers who leave their jobs, cash out plan assets and pay a tax penalty, instead of rolling over the funds into another retirement account. Cash-outs are most prevalent among younger workers, the ones who would most benefit from keeping the money in a tax-deferred retirement account.
Plan administrators usually automatically withhold 20 percent of the balance and sends that amount to the IRS. In addition to federal and state income tax, investors younger than 59½ who cash out have to pay a 10 percent early withdrawal penalty. The potential result: Cashing out $50,000 in 401(k) savings may leave just $35,000 in cash. And regardless of the age, the retirement saver who withdraws plan assets no longer gets the compounded growth the savings would have occurred in the account.
2. Not Rebalancing: The old “set it and forget it” mentality can be problematic, because it can ensnare you in one of the classic retirement plan mistakes: Not rebalancing on a periodic basis (quarterly, biannually or annually). It has gotten easier to complete this task, because a lot of plans now have an auto-rebalance option. A side benefit of using this feature is that it can help take emotions out of the investment process, essentially forcing you to buy low and sell high.
3. Not Diversifying/Owning too Much Company Stock: You know that you shouldn’t put too many eggs in one basket. But some participants don’t realize how much overlap they may have among their retirement funds. It’s far more important to diversify among asset classes (stocks, bonds, commodities and cash) than in the total number of funds. Additionally, if your company stock is an option in your plan, limit your exposure to five percent of your total investment holdings. Sure, the stock may be awesome now, but do you really need to risk your retirement on the company’s performance? Since many companies match in their stock, it is incumbent on you to keep an eye on your allocation…or use that auto-rebalance!
4. Choosing High-Fee Mutual Funds: One way to increase your return without risk is to reduce the cost of investing. If your plan offers index funds, you may be able to save for retirement at a fraction of the cost of managed funds. If your plan is filled with expensive funds, gather your co-workers and lobby your boss to add low-cost index funds to your plan.
5. Tapping Retirement Funds to Pay Down a Debt: Workers sometimes dip into retirement funds to whittle away their outstanding credit card balances and other bills. While the IRS does allow for hardship withdrawals in certain instances, pulling money from retirement accounts should be a last resort, due to the aforementioned fees and taxes. Additionally, many workers who are over 59 ½ are tempted to use retirement assets to pay down a mortgage as they approach retirement. The biggest risk in doing this is that you may deplete your liquid assets to eliminate a debt on a non-liquid one.
March 9 2014 marks the five-year anniversary of the stock market’s recent bear market closing low. That trading day, the Dow Jones Industrial Average was at 6547, its lowest level since April 15, 1997; the S&P 500 was at 676, its lowest level since Sept 12, 1996; and the NASDAQ was at 1268, its lowest level since Oct 9, 2002. Since then, U.S. markets have charged higher. Through the end of February, the S&P 500 has shot up 175 percent and including dividends, returns have more than tripled since the bear market low. For the first few years of the recovery, ordinary investors were largely on the sidelines. The experience of watching a retirement account plunge by half prompted many to say that they would never again put themselves through the pain. But over the past few years, many risk-averse investors have reentered the market, though this time, hopefully a little bit wiser.
Not so fast. According to Morningstar, which regularly reviews investors' performance results versus the funds that they own, people are lousy investors. In fact, in the ten years through the end of 2013, the typical investor lagged the mutual funds in which she was invested by 2.5 percent EACH year. What explains the underperformance? We are mere mortals, who are prompted to make emotional decisions -- at precisely the wrong times -- in our portfolios!
There are two main emotions that infect most investors: fear and greed. In 2007, when stocks were flying high and financial crisis had not yet entered the vernacular, many allowed greed to rule, piling into risky asset classes, like stocks. Then at some point, maybe near the bottom in 2009, or even earlier in 2008, fear prompted many to sell.
Conversely, those who adhered to a more balanced approach were better able to keep those emotions in check. Yes, you may have been handsomely rewarded if you kept all of your money in stocks from the bottom until today, but the fact that so much of your nest egg was vanishing before your eyes in 2008-2009, made it more likely that you would not be able to withstand the pain. That's why the unsexy advice of maintaining a thoughtful, balanced approach to investing, which incorporates periodic rebalancing, can help you avoid the emotional decisions that greed and fear often prompt.
Here are the three ways to keep fear and greed in check:
1. Keep cool: If you had sold all of your stocks during the first week of the crisis in September 2008, you would have been shielded from the additional losses that occurred until March 2009. But how would you have known when to get back in? It is highly doubtful that most investors would have had the guts to buy when it seemed like stock indexes were hurtling towards zero.
2. Maintain a diversified portfolio and don’t forget to rebalance. One of the best ways to prevent emotional swings is to create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities. In September 2008, a then-client shrieked to me that “everything is going down!” But that was not exactly the case: the 10 percent allocation in cash was just fine, as was the 30 percent holding in bonds. That did not mean that the stock and commodities positions were doing well, but overall, the client was in far better shape because she was diversified.
3. Maintain a healthy emergency reserve fund. Bad luck can occur at any time. One great lesson of 2008-2009 is that those who had ample emergency reserve funds (6 to 12 months of expenses for those who were employed and 12 to 24 months for those who were retired) had many more choices than those who did not. While a large cash cushion seems like a waste to some (“it’s not earning anything!”), it allowed many to refrain from selling assets at the wrong time and/or from invading retirement accounts.
Five years ago, when the financial crisis blew across the nation like a massive storm, it left a wake of destruction in its path. The Federal Reserve Bank of Dallas estimates that the total cost of the crisis (assuming economic output eventually returns to its pre-crisis trend), to be between $6 and $14 trillion. To put those big numbers into perspective, the loss amounts to $50,000 to $120,000 for every U.S. household. Ouch! The crisis tested every investor, from the neophytes to the most jaded traders on the street. With five years of distance from the eye of the financial storm, here is my list of the top 5 lessons every investors can take away:
1. Keep cool: There are two emotions that influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed. If you had sold all of your stocks during the first week of the crisis in September 2008, you would have been shielded from further losses (stocks bottomed out in March 2009). But how would you have known when to get back in? It is highly doubtful that most investors would have had the guts to buy when it seemed like stock indexes were hurtling towards zero.
2. Maintain a diversified portfolio…and don’t forget to rebalance. One of the best ways to prevent emotional swings is to create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities. In September 2008, a client shrieked to me that “everything is going down!” But that was not exactly the case: the 10 percent allocation in cash was just fine, as was the 30 percent holding in government bonds. That did not mean that the stock and commodities positions were doing well, but overall, the client was in far better shape because she owned more than risk assets.
3. Maintain a healthy emergency reserve fund. Bad luck can occur at any time. One great lesson of the crisis is that those who had ample emergency reserve funds (6 to 12 months of expenses for those who were employed and 12 to 24 months for those who were retired) had many more choices than those who did not. While a large cash cushion seems like a waste to some (“it’s not earning anything!”), it allowed many people to refrain from selling assets at the wrong time and/or from invading retirement accounts. Side note: the home equity lines of credit on which many relied for emergency reserves vanished during the crisis.
4. Put down 20 percent for a mortgage (and try to stick to plain vanilla home loans (15 or 30 year fixed rate mortgages), unless you really understand what you are doing!) Flashback to 2004 – 2007 and you will likely recall that you or someone you knew was buying a home or refinancing with some cockamamie loan that had “features” that allowed borrowers to put down about 3 cents worth of equity. There’s a good reason that old rules of thumb work. Yes Virginia, house prices can go down. And despite the recovery, please shun the advice from so-called experts like Suze Orman, who are once again saying that 10 percent down is just fine.
5. Understand what is in your target date fund: Pre-crisis, many investors had started to use target date funds, in which the fund manager “targets” your future date of retirement and adjusts the allocation as you near the time that you will need to access the money. Unfortunately, many of these funds were far riskier than investors understood. Whether it’s a target date fund or an age-based investment for your kid’s college fund, be sure to check out the risk level before you put a dollar to work.
“What does your fund manager do?” screamed the headline of the April 8 2013 edition of Barron’s. All I could think was, “What, indeed!” The article says some superstar fund managers “fly around the world, they crunch reams of data, they dissect industries,” and ultimately, they beat the index against which their funds are measured. Here’s the problem: even if there are some diamonds in the rough (and believe me, it’s rough out there in managed mutual fund land!), it may not even be worth trying. The reason is clear: it is very difficult to beat the index after factoring in costs and fees.
A recent survey by the London investment firm Style Research analyzed 425 global equity funds versus the MSCI World index. Without fees, 59 percent of the managers beat the index. However, after investor fees were included, only 31 percent beat the index last year.
And it gets harder to beat year after year, because investors tend to pile into the good funds only after they have beaten their relative indexes. Once new money flows into these funds, costs tend to rise and the funds can get too large and cumbersome for the manager, which together make outperformance more difficult to achieve in the future.
There has been some good news on fees: According to the Investment Company Institute, all mutual fund fees have been trending lower. The average expense ratios for equity funds have fallen from 0.99 percent in 1990 to 0.79 percent in 2011, a decline of 20 percent. But a good chunk of that decline may be attributable to the shift towards no-load (no commission) funds. Actively managed equity funds still have average fees of 0.93 percent, while index equity funds have average fees of 0.13 percent.
How do you find the good ones? It will take some work: you will need to identify active managers with a proven track record, who can consistently stick to an articulated and prudent strategy. You will also want to look for a fund that maintains low investment costs, administrative and advisory fees, plus costs due to portfolio turnover, commissions, and execution.
If you prefer to spend your time in other ways and want to make your investment life a little easier, there’s a simple solution: instead of trying to beat the index, just buy the index! Last month, index fund pioneer Vanguard issued a research report comparing index versus managed funds, and noted “persistence of performance among past [managed fund] winners is no more predictable than a flip of a coin…low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds.”
Index funds have been around since the early 1970’s, but suffered from a definitive “un-cool” status for a long time. It was much more fun to think that some manager held the keys to the investment kingdom and your financial freedom, then to imagine that all you needed was a few index funds in different asset classes. And there was no massive brokerage sales force and marketing campaign blazing the trail for the stodgy index fund. Of course the commission-based broker who was touting managed mutual funds had a great incentive: only the expensive, loaded mutual funds would pay them.
But in the aftermath of the financial crisis, boring has become a bit more attractive. Many investors dumped their managed funds and decided that they would prefer to start the investing year with the extra 0.80 percent in their own pockets. According to fund-tracking firm Morningstar, assets in U.S. index mutual funds and exchange-traded funds (ETFs) accounted for 34 percent of equity and 18 percent of fixed income funds as of year-end 2012.
My hope is to see those levels steadily rise, as do-it-yourself investors wise up or as investors who work with advisors choose fee-only or fee-based professionals who tend to adhere to a strategy of indexing.
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