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The $5.5 Billion Mistake

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Guest contributor Scott Holsopple is CEO of Smart401k, an independent Web-based investment advisor providing advice to help employees invest in their employer-sponsored retirement plans.

The last couple of years have been a roller-coaster ride for many of us. Many individual investors saw their 401(k) swing wildly, as the market plummeted and then rebounded strongly. Many experts expected large numbers of investors to drastically alter how they were invested as a result of the upheaval.

However, almost the exact opposite happened. In fact, Vanguard estimated that only approximately 16% of individuals made a change in their 401(k) account in 2008. Many people took this as a positive sign, but I couldn't help but remind myself that it's only good if they were invested appropriately in the first place. And even if they were invested appropriately, that doesn't mean that they shouldn't be shifting their allocation as circumstances change.

Throwing out your retirement funds in three easy steps
After a bit more research I found that while abstaining from making changes likely helped many employees in 2009, the reality is that employees often make bad decisions with their accounts that could hurt their long-term strategy. Some of the most common are:

  • Chasing returns
  • Overinvesting in company stock
  • Misunderstanding diversification

The result of these common mistakes is underperformance and lost retirement savings. The Labor Department recently estimated that retirement-plan investors routinely make poor investment decisions, costing themselves an estimated $5.5 billion to $10.9 billion annually. Here's how to avoid such mistakes:

  1. Don't chase returns. Fundamental investors know that a lot more needs to go into an investment decision than past performance. For example, Apple (Nasdaq: AAPL  ) went from $140 in June 2009 to its current price of $250 -- an 80% jump over the past year. This may have been great for those that already owned the stock, but new investors need to review the future prospects for Apple's business -- including lead products like the iPhone and iPad -- and not those hefty returns.

    Similarly, many retirement investors pile into funds that performed the best over the last year. That can be a big problem, however, because the top-performing asset class in one year can easily be at the bottom the next year. Before you invest in a fund, do research on factors such as performance versus peers, historical volatility, management tenure, and expenses.
  2. Don't overinvest in company stock. Many investors mistakenly think that owning company stock is safer than owning a mutual fund. Unfortunately, company stock is often far riskier than a mutual fund. Enron employees got clobbered when that company went under, but a company doesn't necessarily need to go bankrupt to hammer its employees' retirement accounts. Rank and file employees who overinvested in company stock at Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , or General Electric (NYSE: GE  ) -- infamous victims of the credit crisis -- may be facing the unenviable task of reevaluating their plans for retirement. The general rule of thumb is to own no more than 5% to 10% in company stock.
  3. Don't misunderstand diversification. Buying all technology stocks like Cisco, Microsoft, and Oracle would not give an individual stock portfolio diversification. Similarly, a retirement account isn't diversified just because it has multiple funds. Diversification actually means that you are invested in several different asset classes (e.g., large-cap, small-cap, international, bonds, etc.). Proper asset allocation will also take other factors into account such as age and risk tolerance. For example, a conservative investor could have a portfolio of approximately 70% bonds and 30% stocks; whereas a more aggressive investor might have a portfolio of 20% bonds and 80% stocks.

Turn the beat around
If you're wondering how you can avoid contributing to the massive amount of retirement plan losses caused by common investor mistakes, there are two options to consider.

First, get help. There are a number of unbiased investment advisors that offer web-based services. I'd suggest an independent investment advisor who clearly discloses their fees and their fiduciary duty to you. If you decide to go this route, make sure that your advisor takes your risk tolerance, time horizon and investment goals into account.

Alternatively, do it yourself. If you decide to manage your own account, I'd recommend doing the necessary research to be able to, at a bare minimum, identify your risk tolerance and a proper asset allocation for your situation. These two things will provide you with a roadmap to selecting appropriate investments for your account.

More on retirement planning:

Scott Holsopple does not own any of the companies mentioned; however, Scott's clients may have such positions. The Fool owns shares of and has written puts on Oracle. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (47)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 10, 2010, at 5:05 PM, TMFKopp wrote:

    @Scott

    When it comes to diversification, how should investors approach the finer distinctions of small-cap versus large-cap, domestic versus foreign, government bonds versus high yield, etc?

    Matt

  • Report this Comment On June 10, 2010, at 6:41 PM, SRHCAPS wrote:

    @TMFKopp - Good question.

    Unfortunately, there isn’t one right answer to your question. Each individual needs to first understand what type of investor they are – i.e. aggressive, moderate or conservative. Then I would recommend doing a bit of research to better understand the risk and volatility of each asset class and what/if any correlation exists between each type. After doing these two things you will have a better idea of the mix of asset classes that are appropriate for your account.

    In general - small cap stocks are riskier/more volatile than large cap stocks, foreign stocks more so than domestic stocks and high yield bonds more than government bonds.

    At Smart401k we base our recommendations on our assessment of each client’s situation which takes into account their risk tolerance, time horizon and investment goals.

    Hope this helps,

    Scott

  • Report this Comment On June 10, 2010, at 6:47 PM, alogan43 wrote:

    Scott,

    If you are doing your own investing at what point after a crisis occurs would you rebalance your portfolio to minimize your lose? Are there any sites you would recommend to help you do this or would you recommend only using a trusted financial advisor to handle this?

  • Report this Comment On June 10, 2010, at 7:24 PM, SRHCAPS wrote:

    @alogan43

    IMO, rebalancing should be used to get your account back to your target asset allocation rather than to try to anticipate/time a market change. We generally recommend rebalancing your account 2-4 times per year based on market/economic conditions. This regular rebalancing will help you to take the emotion out of making changes to your account which is especially helpful during volatile market’s like the one we are in currently.

    If you plan to continue managing your account, I’d recommend reading as much as you can on sites such as the one you are on now. The Wall Street Journal and Kiplingers are two others that I enjoy reading. And if you ever decide that you want a second opinion we’d be excited to work with you - www.smart401k.com.

    Scott

  • Report this Comment On June 11, 2010, at 11:11 AM, ozzfan1317 wrote:

    So would I be considered aggressive if the flucations in my account I can stomach and I have no interest in owning bonds?

  • Report this Comment On June 11, 2010, at 11:37 AM, SRHCAPS wrote:

    @ozzfan1317

    If your account is 100% equities i'd consider you an aggressive investor.

    Scott

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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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