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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:
- 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.
- 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.
- 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.
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