Avoid Chasing Your 401k Tail

September 28, 2009 at 3:45 am Leave a comment

Chasing Tail

David Laibson, a professor of economics at Harvard University, has done extensive research on the savings habits of Americans in their 401k retirement accounts. What he discovers is that workers, like a dog chasing their tail, allocate more of their investments to the areas that have done well and sell the underperforming segments. In short, workers attempt to “time the market.”

Professor Laibson demonstrates this pyramiding strategy has not worked out so well and provides the following advice:

“We know that individual investors are terrible in terms of their market timing. They tend to buy at the tops, they tend to sell at the bottoms. So don’t try to time the market. Don’t think about recouping – just think about a long term strategy.”

 

That long term strategy he advocates entails a diversified allocation of stocks and bonds that reduces exposure to equities as a person gets older. In short, he says, “Hold a diversified portfolio appropriate for your age.”

He advises those aged in their 20s and 30s to allocate nearly 100% of their portfolio to equities, or investments with commensurate risk. Alternatively, if investors don’t want to adjust the allocation themselves, people should consider life-cycle funds or Self Directed 401k options (Read story here). For those in retirement, he recommends a portfolio with the following characteristics:

“30, 40, 50% should be equities, more as you’re younger…simply hold a long term portfolio with less and less allocation to equities as you age.”

 

Jason Zweig, a journalist at The Wall Street Journal, recently chimed in with similar thoughts on performance chasing:

“…to buy more of what has gone up, precisely because it has gone up, is to fall for the belief that stocks become safer as their prices rise. That is the same fallacy that led investors straight into disaster in 1929, 1972, 1999, 2007 and every other market bubble in history.”

 

There are many different strategies for making money in the market, but a plan based solely on emotion is doomed for failure – Professor Laibson’s data supports that assertion. So the next time you are considering re-allocating the mix of investments in your 401k, implement a disciplined, systematic approach. That approach should include the following:

1)      Invest Your Age in Fixed Income Securities. John Bogle, Chairman at Vanguard Group, has long made this argument, with the balance placed in equities. For example a sixty year old should have 60% of their assets in bonds and 40% in stocks. This rule of thumb is a good starting point, but the picture becomes cloudier once you account for other assets such as real estate, convertible bonds, and income generated from private businesses.

2)      Periodically Rebalance. Rather than investing more into outperforming areas, harvest your gains and redeploy into underperforming segments of your asset allocation. There obviously is an art to knowing “when to hold them and when to fold them,” nonetheless I concur with Professor Laibson that chasing winners is not the proper strategy.

3)      Diversify. Spread your assets across multiple asset classes, segments, and styles, including equities, fixed income, commodities, real estate, inflation protection, growth, value, etc. Too much concentration in any one category can really come back to haunt you.

The key to successful retirement planning is to implement an unemotional systematic approach, so you don’t end up chasing your 401k tail.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

*DISCLOSURE: At the time of publishing, Sidoxia Capital Management and some of its clients owned certain exchange traded funds, but had no direct positions in any other security referenced.

Entry filed under: Asset Allocation. Tags: , , , , , , .

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