This week I will respond to two questions. The first comes from one of our clients -- he
is an
employee of a company that has hired mPower to deliver advice to participants on their
401(k)
investments. (mPower also publishes this web site.) My answer offers insight into how an
investment
advisor selects funds.
The second question is a doozy, so be sure to stick around to read it.
Here's question one. In the interest of not naming names, I took some poetic license.
Dear Scott:
In addition to an international fund, a bond fund, and two other domestic funds, your
company's
recommendation suggests I put 24% of my money in "The Really Boring Mutual Fund"
(RBM) and
nothing in the "Sexy and Exciting Value Fund" (SEV). However, SEV has
outperformed RBM by
an average of 7% per year over the past five years. Why do you ignore this performance in
making
your recommendation?
There are two general tenets we follow that are relevant to your question. The first is
that we do not
merely chase past high returns. Simply buying the fund that performed best in the past may
look
good on paper, but it typically leads to disastrous results. This is because funds that
have provided
very high returns usually take high risks as well. And sometimes, those risks don't pay
off. Also,
simply picking funds that performed well in the past leads to a group of funds that is not
diversified.
These funds performed well at the same time because of a factor related to them all, and
if that
factor no longer holds, their performance may suffer en masse. Our company's analysts do
take past
performance into account, but we also analyze the reasons for the performance and research
the
potential risks of the fund.
The second tenet is broad diversification. We don't want our clients overexposed to any
one sector
of the market. This means we look at each fund not only in isolation but also in
combination with the
other funds in the client's portfolio.
For your allocation, we have two other domestic equity funds -- the broad-based
"Quantitative
Index Fund" (QI) which provides predictability and stability, and the "Very
Highly Priced Stock
Fund" (VHPS) which invests in a mix of large and small companies with high growth
opportunities.
In determining which fund, RBM or SEV, is a better addition, we would consider several
factors:
RBM invests primarily in value-oriented stocks (stocks that have a lower price-to-earnings
ratio). SEV used to be a value-oriented fund, but over the past few years it has switched
its
style to mainly growth stocks (such as Dell, Gateway, AOL, and Nextel). While these are
fine companies, their stock prices will clearly be high, which encompasses a greater
degree of
risk. More importantly, this fund's new investment style exposes it to many of the same
risks
that the VHPS fund has. Hence, RBM relates better with the other funds in your portfolio.
RBM fund offers broad diversification across industries. No more than 20% of fund holdings
are concentrated in any one industry sector. Over 60% of SEV's holdings are in two sectors
-- financials and technology. This adds to the fund's risk.
RBM has broader security diversification. No individual stock comprises more than 3% of
RBM's holdings. Meanwhile, SEV has invested over 14% in AOL.
Over the past year, SEV has displayed some of the potential risk discussed above. During
the second and third quarters, the market showed some weakness, earning slightly over a
2.5% return. SEV lost over 4% during the same period, due to the volatility of higher-risk
investments in its portfolio.
None of this is to suggest that SEV is a bad fund. However, to accomplish your goals
you're willing
to accept a relatively high level of risk, and for that risk level we recommend a
combination of RBM
with your other funds.
Our objective is to create a fund allocation that works well in a variety of economic
environments,
not just that of the past 5 or 10 years. Of course, the market may continue to show
impressive
returns in the future, and Internet stocks may continue to blossom. If that occurs, your
portfolio will
thrive as well (although perhaps not as much as SEV). However, should we see a large
market
correction, or a settling of values of Internet and technology stocks, investors would
regret
overexposure to risky growth-oriented stocks. Our job is to try to prevent such regret.
And now, the second question.
Dear Scott:
I have $53,000 in my 401(k) right now. I will be 59 years old in 2010. I want to realize a
30%
return annually until then. Is this unreasonable to expect?
Come close because I want to whisper the answer to you.
Scroll down for the answer:
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YES, IT IS UNREASONABLE TO EXPECT A 30% RETURN ON YOUR INVESTMENT!!!!
Sorry, I had to get that out of my system. But one aspect about investing that most
concerns me
right now is the unrealistic expectations some people have for their investments' future
returns. There
has never been a 10-year period during which stocks have earned even close to 30%. The
largest
ever 10-year return was 19%, and a much more typical average is 11%. You planning for
retirement based on an assumption of a 30% annual return is like me making dinner
reservations for
a date with Michelle Pfeiffer. It may be fun to fantasize about, but it's not going to
happen.
There is one key difference between our two fantasies, however. My unrealistic fantasy is
harmless.
But the fantasy of expecting 30% returns will lead to drastic under-investing, and instead
of dining
with "Catwoman" you will be dining on cat food. Do not expect a return of much
more than the
historical average when planning for your retirement.
Now, Michelle, if you are reading this, I was only kidding about the dinner being an
unrealistic
fantasy.  Lummer's Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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