As my husband and I were sitting with a couple of great friends watching our young girls playing together, we were lamenting about our retirement plans, or lack thereof. It seems we both have dance lessons, proms, college degrees and weddings to pay for in our futures. The conversation eventually turned to my friend’s 401(k) account and how he had come to make the investment decisions that he had. He said, “I just look at the performance and choose the best one. How else are you supposed to decide?”
My friend had fallen into the trap that so many average investors out there fall into and that is selecting his investment allocation on performance alone. This can be a very risky way to plan your retirement future. As I explained to him, there is a very good reason why our industry’s favorite disclosure statement is “past performance does not indicate future results.” Take a look at the chart below. It illustrates the volatility of asset class returns from year to year by ranking certain key indices in order of performance. You will note that top-performing asset classes in a given year do not tend to repeat their top performance in following years and the lowest performing asset classes often outperform in subsequent years. Accepting that simply selecting your investments based on historical performance may not be the best way to go, you still have to answer the question, “How are you supposed to decide?” If you are a member of your company’s investment committee or if you simply have an investment account of your own, this can be a very important question to ask. The committees with whom we work decide the investments offered to the plan by examining risk tolerance, time horizon, and diversification.
First and foremost, it is important to analyze and understand the risk tolerance of the group who will be utilizing the investments. Risk tolerance can be thought of as how willing a group is to subject the account to potential losses in order to get potential gains. In other words, are you or your group able to stomach the thought of losing in the short term in order to reap long term gains? Or at the first sight of loss, are you going to pull your money and run? Risk tolerance for an individual may be a little easier to determine than for a group; in determining what is appropriate for a group of employees, you have to use different methods. When we analyze appropriate investments for a 401(k) plan, we look at upside/downside capture ratios in order to help determine if the investment manager is taking an appropriate amount of risk and being appropriately rewarded for that risk. Upside/downside capture can also help determine how a manager will perform in down markets and manage the risk for the employee population as a whole.
Another factor to consider is the time horizon of the investor or group of investors. In application for a 401(k) plan, we analyze employee demographic information to determine the age range of the workforce, which can assist us and committee in deciding an appropriate investment menu. Additionally, we review with the plan sponsor whether the employees typically leave their money in the plan at retirement or if the funds are removed prior to or at retirement. This helps us to determine the time frame for the team of employees.
Finally, diversification in the investment menu can be important in shaping successful investment strategies. We’ve all heard “don’t put all your eggs in one basket” and that basic tenant best describes the idea of diversifying investments. As the chart above shows, if you have all of your investment dollars in one specific type of investment, there is a better chance that you will experience more volatility then if you spread your assets over a variety of asset classes.
Deciding how to allocate your personal investments or how to best design a 401(k) menu is challenging and it may seem that the easiest path is to make those decisions based on performance. However, if you or your 401(k) committee would like to take a more in depth look at the appropriateness of your investment strategy, please contact me today.
Jamie Kertis, AIF®, QKA
Retirement Plan Specialist
Grinkmeyer Leonard Financial
1950 Stonegate Drive / Suite 275 /Birmingham, AL 35242
Office: 205.970.9088 / Toll-Free: 866.695.5162