When I worked as a portfolio manager, I had quite a few 401(k) plans cross my desk. Many clients would ask, "Do you mind also looking at my company retirement plan?" Obviously, I wasn't going to turn down my customers' requests. But after a while, I did mind -- because I knew what I was going to find once I took a closer look.
Smart people, dumb decisions
The latest such incident occurred with my attorney, while I was getting advice on a legal matter. Knowing I am an avid investor, he said to me: "I put my faith in the system. I invested in all the funds, but they still went down. What did I do wrong?"
Unfortunately, this is typical of the way many people think. They figure that the more funds they invest in, the better off they are. In truth, of course, this approach doesn't do them any good.
Here's the main issue: Many retirement plans have way too many funds within the same category -- especially common designations such as "large-cap growth" or "large-cap blend." If an unknowing investor buys in equal allocations into every fund available to him or her, that investor will probably have too much large-cap exposure, not much mid- and small-cap exposure, and a tiny amount of international exposure, mixed in with a variety of bond funds and other niche investments.
Overdiversification
Some investors think that the more funds they own, the more diversified they are. But there is such a thing as overdiversification. If a fund already has 100 stocks and you own 10 to 15 funds, your portfolio will end up with most of the stocks in the S&P 500.
But you won't be nearly as well off as those who invest directly in a single index fund. The reason: With many stock funds charging 1% to 2% or even more, your expenses will be much higher than they would be with a typical S&P 500 index fund, which can be as cheap as 0.1% or 0.2%. By buying a bunch of funds, you find yourself in a dire situation: You end up diversifying yourself into an index fund -- but with expenses up to 10 times as high as the typical index fund offers.
I'll bet you can guess who wins that investment race.
Solutions
As long as asset managers such as Janus Capital (NYSE:JNS) and T. Rowe Price (NASDAQ:TROW) can manage to outperform their benchmarks, then they should be fine. But if they underperform, they could easily lose clients quickly. Bigger financial firms such as JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) also have exposure to funds, but at least they have a more broad-based business that goes beyond asset management.
If these companies want to keep their retirement-plan business -- and I am sure they do -- they need to find ways to outperform their benchmarks. Otherwise, investors might choose to not contribute -- an action that would inflict greater long-term damage to their portfolios and take away business from fund managers.
But the better option for some workers is to take matters into your own hands and invest on your own rather than use less-than-perfect funds within your 401(k). Still, doing so is easier said than done, since 401(k) plans are purposely designed in a rigid manner to keep participants locked in. If your employer is participating generously and matching a big part of your contributions, then the negative expense effect is somewhat muted. But big employer matches are becoming a rarity in the current lean times.
Lean times, indeed
A recent survey by the Spectrem Group found that U.S. companies are cutting back on matching retirement-plan contributions in an attempt to save cash. General Motors (NYSE:GM), FedEx (NYSE:FDX), and Eastman Kodak (NYSE:EK) are recent examples. Of 150 U.S. companies that were surveyed, 34% have reduced or eliminated retirement-plan contributions since January 2008. In the next year, another 29% intend to scale back or eliminate their matches.
The key lesson for investors is never to have blind faith in any system. Find out and keep tabs on the costs associated with your plan, and look at your portfolio holistically to avoid overdiversification. Otherwise, the 401(k) model doesn't work in your favor.
Check out the Fool's free PDF report on how to save your 401(k).
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