The DOL asks the Tough Questions about Your 401K

Hearings began concerning your 401(k) and the Department of Labor proposal to change the rules that currently apply to brokers. Now it’s okay to not know that there were hearings taking place at the DOL. It’s even okay that you may not have known that the DOL is even concerned with brokers. And if you didn’t know the role brokers play in your retirement plan – thinking of course that they were only traders of securities on an individual level – that’s fine too. But what the DOL is proposing is both significant and insignificant and worth noting nonetheless.

So I thought I’d give you a brief overview of what is happening, why some are enthusiastic about the change and others much less so. The DOL wants brokers and investmentconsultants to comply with the fiduciary standard of care as outlined in ERISA. This standard of care is worth noting and probably something you thought was already part of the whole package in your plan. For the vast majority of us, the 401(k) is benign tool, important but so nuanced in so many ways as to be opaque. We use it and hope for the best. (Not saying that’s the right approach but for most of us, it’s true.)

But there are people like me and institutions like the DOL who think that you should know otherwise. So we encourage you to listen to the background noise. This noise, currently being conducted as hearings has had a steady stream of industry professionals testify that they like the proposed rule changes and that they don’t.

The rules that the DOL would like to enact consist of the following: offering ERISA covered advice. This sounds simple enough but the reasons so many firms are fighting the rule changes is in large part due to the cost, which many have claimed would be passed on to the clients and then to the end-user of the plans, us.

Along with disclosure of conflicts of interest, Helen Kearney of Reuters reported recently “The standard would limit brokers’ ability to recommend their firms’ proprietary investment products to employers and prohibit them from collecting commissions from product sponsors.” Those objecting most vehemently to the rules are the smaller firms that do not offer compliance departments as part of the services they provide. And it is also quite possible that their clients don’t want to pay for that extra level of protection.

To offer fiduciary care comes with a cost. To act as such, the investment adviser/broker essentially stands with the company should their be any problems with the plan. The proposal would require that these brokers tell the company upfront that there may be conflicts of interest and the products they are selling them are the products their firm has instructed them to sell. This might not be the best analogy to use, but it is similar to buying a store brand which tends to be cheaper and a national brand, which tends to cost more. The product itself might be the same in many respects, but the differences, albeit small are there.

The biggest fear these firms have is rejection. If clients walk away, then what? That might be more ghost in the machine thinking but for some brokers who peddle in-house products, believe in commissions and don’t necessarily want to shout this fact from the mountain tops, they are balking at the notion.

Small companies usually deal with smaller brokerage houses in their 401(k). In these cases, the fees they receive are smaller than a Wells Fargo or Merrill Lynch might charge its clients. Those smaller brokers would be jeopardizing their fee base, received in addition to their charges for services are as part of the products they recommend, even if those products are the right ones for the client. So they might be forced in light of the DOL  rules to increase the fees they charge to these small businesses.

But these folks shouldn’t fear the worst. If they are doing their jobs and that, by definition is tailoring their products to the client, suggesting that if they include them in their plans, they will more likely than not, increase plan participation, they should have no worries about losing clients. And that, after all of the dust settles, is what they are supposed to be doing.

Smaller companies often use third party administrators to help with the heavy lifting and the legal issues. They can in many instances help the client choose which funds might be best.

So many brokers do not, under the proposed DOL rules, need to accept the fiduciary standard of care to stay in business. But you can bet that this will be the selling point the largest firms will begin advertising they have to offer.

According to Brian Graff, executive director and CEO of the American Society of Pension Professionals & Actuaries: “players in the retirement industry who are more formally regulated with extensive compliance departments will comply with the rules, and those less formally regulated who know there is no practical enforcement of the rules, will choose not to comply.” It looks as if it boils down to your plan’s decision over whether to buy the store brand or the national brand. Do get the same thing or do you get what you pay for?

Another Retirement Planning Study on Women

There is another study out this past week, this one conducted by the Hartford, on the state of retirement. Beyond knowing where you stand on the subject, a point in time that seems to defy statistical reports such as these, the feeling that we are mostly under the microscope of planners and brokers and insurance agents is becoming annoying. The Hartford study on the retirement plans of those in a post-Great Recession world reveals some interesting percentages. Yet the back story is somewhat concealed in those facts and figures.

It is nice to see that women are participating in their retirement plans with a great many of them seeking to gain some sort of comprehensive understanding of exactly what these plans are. No mean feat by any stretch and a struggle that men have seemingly come to grips with, given up on or otherwise recoiled in risk averse fear. Women it seems are on the verge of doing the same thing. And the journey might be different; then again, it might not.

The Hartford suggests that retirement plan participation rates increased among the female workforce - but fails to mention that so did the overall female make-up of the workforce. The study also fails to mention how many of these women were swept up into the auto-enrollment mandate.

The study also suggested that this group completely or mostly understood their retirement plans (401(k)s). Which I suppose on the surface is a good thing to know. But the study doesn't necessarily test that knowledge - they simply take their surveyed answers and make some educated guesses.

Comprehension is the biggest struggle facing anyone who must use their company's retirement plan. How those plans are being used, which investments are favored the most, and how well the participants understand the importance of making regular contributions is of great interest to not only the government and Wall Street but to those actively selling, tweaking or otherwise sponsoring these plans.

Comprehension and increased participation doesn't point to higher rates of investment savvy nor do they suggest that enough is being put away to make a difference. Few people are capable of completely understanding the methodology of investments, know what risk is and how to use it. Fewer people are willing to make serious financial sacrifices while they are working to maximize the potential of their retirement plans. And even fewer still, make enough of a contribution to matter.

There was a stat in that report that suggested that many participants reduced their contribution or even stopped altogether citing economic hardships (about 22%). This also correlates with the number of employers who stopped matching or reduced their matching contribution.

While the study doesn't give us the survey questions, it would be interesting to know if those surveyed were asked if they knew what vesting was, how long their employer held their contribution before they actually gave it to them and if they were aware that they could maintain their current take-home pay with a pre-tax contribution of about 4-5%?

Vesting, for those of you who may not know is the time between when you are hired and the time you have access to your retirement plan. This varies with the best plans making it available soon after your first day on the job to up to two years. Businesses do this when they fear higher turn-over (a sign that job dissatisfaction might be higher in this job and the company has reacted by trying to hold on to their contribution in the even you might flee soon after orientation).

You might be auto-enrolled in your 401(k), but it doesn't mean you own the plan or the money your employer may have contributed on your behalf. What you do own is what you put in. That 4-5% rule is often downplayed in favor of the matching contribution, which is not free money as many say it is and it is not free of strings. In the post Great Recession era, that "free money" may actually be the only pay increase you might see. It might also come at the expense of other benefits such as health care.

And auto-enrollment doesn't suggest benevolence. It suggests a fund that the company has the smallest liability in offering a new employee who may or may not have a clue. Often these "suggested" investments come in the form of a target date fund or a low-cost index fund. Neither of these is necessarily bad for the new worker. But so much attention has been devoted to reducing risk (liability) and fees (which often come at the expense of good choices for a wide demographic of workers) that these plans, even if you are automatically enrolled are much more sterile than they were just a couple of years ago.

The 4-5% rule is relatively simple and should be used match or no match. Setting your account up to have this amount withdrawn will not impact your take-home pay. Once you become comfortable with this, and perhaps have taken the hour or two needed to become accustomed to the plan you have, the only way you will be able to increase your chances of not being poor in retirement is to begin increasing your contribution.

Increasing that retirement plan contribution can be done in a number of ways. Channel your pay increases into the plan. Forward your bonus. Reduce your debt and in doing so, use the money you spent on debt service (interest) and use it to increase your retirement plan balance. Or simply live a little smaller now knowing that it will be easier to do so while you are earning money.

Why Some Company Matches Fail to Match Your Objectives

Just because there is a company match doesn't make it the match you should take.

We know about diversity.  We know about spreading the risk.  We know that we are supposed to be investors, eyeballing retirement. We should know better. Why then, do we continue to take the offering of the company's stock in our 401(k)?

There are several reasons.  First of which is how your company’s 401(k) plan in structured. When an employee becomes eligible to begin investing in the plan, they often find that the company match, the funds the company invests with you, up to a certain percentage, is often only offered in the company’s stock.  And because we are always suggesting that the employee take the company match, at the very least, they take our advice and begin to load up their portfolio with shares of their employer.

Often, when this sort of offering is available, it is one of the few buy-and-hold restrictions in the plan.  That means that if the fortunes of your company drop, for whatever reason – poor quarterly earnings, lackluster forecasts or simply a cyclical turn of events, the employee must ride out the downturn. This can be a big deal if the employee is long-term and because of that, has a huge chunk of their retirement tied up in that stock.

More on owning stock in your company.

Paul Petillo is the Managing Editor of Target2025.com

Retirement Planning: Fixing Wall Street with Moral Authority

Ask any cop on the street for their assessment of a drug bust. It goes, they will tell you something like this: “Sir, may I search you?” “Yes.” “There is crack in your pocket.” “Not my crack.” “But sir, it was in your pants.” “Not my pants.”

There are two key elements of success on Wall Street that President Obama overlooked when he addressed the financial crisis a year past. The first is the crisis itself.

To which the conversation would proceed something like this: “Sure. Go ahead and try to figure out where we took risks, what those risks were and why those risks were not our fault. Search all you want.” “You took those risks because there was no real regulation governing what you did.” “Not my problem.” “Then we should begin to look for these problems so it doesn’t happen again.” “Not at my financial institution.”

Ask any cop on the street and they will tell you that the drug busts they often make are due to stupidity and ironically, bad driving habits. Ask Wall Street and they will tell you the appetite for risk drove them to do what they did. Ask any cop on the street and they will tell you that the more felony laws you break, the less misdemeanors matter.

The second reason we still have lingering effects from what happened last year is reckless behavior. Had the appetite for increased risk not been laid on the doorsteps of our financial institutions (by the Bush administration in the form of ridiculously low interest rates, lax regulations and tax-based, incentive-based rewards for bad behavior), the address at Federal Hall would have been far different.

Wall Street bankers choose not to attend the meeting on the anniversary of the collapse of Lehman Brothers. Much like maligned athletes who do as they please, these CEOs do not want to be role models. The president was seeking what he refers to as “a broader sense of responsibility” when it comes to how they act, prodding them to lead the financial markets in the right direction. Knowing that the cameras would be trained on every facial tick, every sigh and every uncomfortable shift in their chairs, much the way the CEOs of the big three car companies were scrutinized, they stayed away.

Where Mr. Obama missed the mark was in taking the strength of his general popularity into the den of thieves, where his championing of the worker is often met with open derision. Suggesting that these financial titans should be beholden to the average citizen means the shareholder should be relegated to a lesser role in terms of consideration. To do that, the public sector would need to step in. And this is where the divide begins to widen.

Risk has never been adequately defined. For the small investor, it is a soul-searching exercise that is often fraught with anxiety and overtly quixotic. Unable to hedge their stance the way more savvy investors do, they simply take risk at face value, not as a mechanism designed to grow investments. The confusion starts for this group when they refer to their interaction with Wall Street (largely through their retirement plans and even though many were unaware, home ownership) as savings.

For the large investor, risk is the only reason they do what they do. Exotic products make the experience much more interesting and profitable. Lack of oversight makes the thrill doubly enticing. Using the government as a hedge against losses (not only of share value and assets but bonuses) made the process even more appealing. Is it any wonder that the headwind facing the president has picked up speed?

The main issue is how to regulate and protect. Currently the government does not have a single agency that can act in advance of such a storm. Having knowledge of an impending crisis would require you to have the ability to evacuate the innocent. Having that knowledge would require a federal agency to have much more private access to information than any publicly elected official would want, even the president.

We rely on the ability to learn lessons instead. Yet Wall Street uses another mechanism to understand the way markets work: forgetfulness. Understanding that politicians come and go suggests to these top financial folks that regulations should be either more fluid, able to evolve with the markets, or simply non-existent, employing a buyer beware sticker on each new product that makes its way to market.

Sen. Bob Corker (R., Tenn.), a member of the Senate Banking Committee suggested more introspection in the process: "Financial regulation needs to be done in an atmosphere of thoughtfulness." In other words, not at all. But reform does need to come in some shape or form. Doubts remain whether the president’s proposal of creating a consumer oversight committee to provide this sort of thoughtfulness will ever make it into law.

The ripple effect that spread in the aftermath of September 2008 still lingers in most of America. Billions of taxpayer dollars disappeared in an effort to bailout a system that few outside of Wall Street understood. Now we understand that the methodology employed by these brokers/traders/dealers/bankers offered no projection or even entertained the possibility of a fallout turns this into a politically charged topic. The moral authority of the president and his insistence that this will not happen again will turn this kind of regulation into a turf war with conservatives and financial interest groups.

Those that were instrumental in creating lax regulation will need to find a common ground with those that seek retributions for the market loses that followed the near-collapse of the financial system. The problem is determining which agency is best equipped to handle the new responsibility?

The Fed may not be the best choice. Their inability to see the crisis coming and possibly their own accommodative stance make them a poor candidate. The FDIC, which oversees the nation’s banking system doesn’t see their role as protector expanding to include all of the financial markets. Their grasp of regulation is still, even in the aftermath rather weak.

The Treasury would be an attempt to control by committee. Although Treasury Secretary Timothy Geithner pointed out that the Fed is both incremental and essential in the president’s plan, the markets, Wall Street is quick to point out, have begun to recover without any new oversight. Forget economists.

The bailout should not be cure enough. In many instances, it came without ties or questions and has even been offered back to the government. Doing so, often before it was clear that the bad times were ending suggests that Wall Street is aware that regulation would hamper their efforts at delving into new and more complicated methods for making a profit.

The cycle of dramatic financial events is shortening. While some suggest that this type of regulation will protect us ten years from now, there is a greater likelihood that another similar event will shake out in a matter of years. This also suggests that regulation is needed yesterday more than ever.

As the president searched Wall Street for answers to why they did what they did, they simply replied: “Not my pants.”

Retirement Planning - 401(k) Transparency For Some

Your level of expertise often directly affects how well you do when it comes to investing. The financial acumen, the ability to sift through reams of documents, and to keep track of third party involvement is not usually the forte of the small business owner. They may be well versed in what they know, how to make and market their skill or product, how to keep employees loyal to your vision and how to think big. But add a broker or retirement plan sponsor to the mix, and most small business owners, thinking they have done good by their employees and themselves, don't go far beyond the handshake agreement they make with these financial firms.

And that is too bad. When a plan sponsor approaches a large corporation, chances are there are people within the company who specialize in watching for cost overruns. They are able to spend the time (or already know what to look for) sifting through the documents the sponsor has provided, looking for hidden fees that could impact not only the employees but the business itself.

Add to that, these sponsor have the ability to spread these costs over a wider pool of employees, essentially cutting the costs. But when these same sponsors appear on the doorstep of the small business, this is not often as clear to the purchasing manager as it should be.

While Congress is attempting to offer a solution, it will still require the small business owner to look at these plans in depth and on a relatively frequent basis. The impact of hidden fees can often be devastating to the invested dollars of the small business employee. It has been estimated that even a one percent fee, over a the course of a lifetime of retirement investing could cost as much as 17% in potential returns.

Changes in the way plans are sold, revising disclosure of the costs in real dollars rather than percentages would drive the small business owners to comparison shop. Recent studies have suggested that small business owners pay as much as twice what their larger counterparts do.

But these smaller employers do not have to wait until legislation comes down the pike to make changes yourself. Demand disclosure of fees. Require those fees to be listed in real dollars. And understand the importance of small 'nickel and dime' costs in the long range rewards that could be had by not only you, but your employees as well.

Why Investors Do What They Do: The Effect of the Media Hype on Investors

Has the hype in the media over the last several months had an effect on how you invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television.

Thomas Schuster, who wrote the book "The Markets and The Media" suggests that television news has changed the way investor's react and eventually what they do. "Novices," he writes, "receive their basic training in investment issues via the media, even via such an improbable candidate as television."

Because the news is interested in only short-term events, Mr. Schuster worries that that sort of focus "provides explanations which afterwards evokes an impression of logic". There is unfortunately no way for even a savvy investor to parse that sort of information, see a developing trend that encompasses both the past and the recently reported story and make any sort of logical decision. But people do.

And the reason for this is pure coincidence. Sometimes your perception and the reality of what is happening meet and when they do, there is often a seismic shift in not only how you view your investment strategy but fundamental values as well.

There is no rational for this type of behavior short of we just do it. We treat stock information garnered from television, even stations devoted to the interactions of business and their shareholders/investors as if it were information worth having. There has been some speculation that the real traders understand this and seek to profit from this sort of non-knowledge.

It is as they say, much easier to swim with the tide. And many traders are now focused on doing just that, predicting when their colleagues, other investors all begin to believe something is worth more than they know it should be worth. The benefit these traders have is knowing that they are investing on emotion and because of their cold-hearted approach to the subject, bail long before the rest of the group realize what it is that they don't know.

So what do we do? The best thing would be to cancel cable and turn off the television. But that isn't going to happen. So the following three suggestions might help.

First: examine why you did what you did in the first place - you know, before you began to question those motives. Chances are you were probably right. If you used your retirement plan according to the time-honor, take-a-lot-of-risk-when-you-are-young method of investing, you probably should go back to that. That is, if you have changed. The most recent news has sent folks scurrying for the less risky forms of investments in their portfolio largely in part because of how the news portrayed the stock market's reaction the global financial crisis.

If you did, keep in mind that "the crisis" affected everyone, equally it seems. The second thing to remember is that you are not the only one with a damaged portfolio. If you managed to keep your job, weren't too deeply in debt and for all intents and purposes, are saving more, your approach to retirement should not have changed. Although the economy (even the global one) will not recover evenly, it will in fact recover with time. If you had spread your risk across four or five sectors (growth - large, mid-cap, small-cap, international and emerging markets) you would have covered all of your bases and be on the way to a decent recovery.

Third thing to remember is that this will take awhile. If you do not feel as though you have enough time I have bad news: investments take time and worse, take their own sweet time returning to normal. But as renowned economist and thinker John Kenneth Galbraith once suggested, the market has no memory. But you will often recall the pain of a loss much more vividly than the market does and this will keep you from making the correct investment decision when you are most emotional, which is often in the aftermath of some new piece of news.

If you have a short horizon, you need to either lengthen it or reevaluate what your plan intends to do for you if you do not allow it to recover before you start drawing down the assets.

Next up: The negative effects of optimism.

Why Investors Do What They Do: Narrow Framing

In our previous discussion about loss aversion, we looked at what was the beginning of Kahneman's prospect theory. Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk. More importantly, a discussion about regret.

When you (or as you are often referred to when being discussed by economic types, an agent) moves into the stock market, be it through individual ownership or through mutual funds, you are changing your wealth allocation. Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret.

This regret is the result of accessibility and the misuse of the different decision rule. Accessibility is what it is: information that is readily available almost instantaneously through any number of mediums and the ability to enter into the market without restrictions. The different decision rule is described in Walter L. Wallace's book "Principles of Scientific Sociology": [the agent]"chooses whichever means optimizes the end in question". This thinking is looking for what could be crudely referred to as the most bang for the buck. Freud called this the pleasure principle.

Narrow framing demands a high equity return both now and in the future. Does this take into account market shifts, both up and down? Not really nor is a realistic approach in the long-term. But loss aversion and narrow framing are not separate thinking.

One of the most famous examples was described by Paul Samuelson, a noted economist, Nobel Prize winner and the person who bridged theoretical and applied economics. When he offered to flip a coin, the prize being $200 if the flip went his colleagues way of loss $100 if the flip went Samuelson's direction, the colleague declined on both accounts. This is loss aversion. When the perception that the loss is greater than the possibility of winning, the investor tends to freeze.

The different decision rule is often described as a way to optimize the end so as not compromise or to incur the minimum amount of cost. Luigi Guiso of the Einaudi Institute for Economics and Finance Via Due Macelli in Rome tested narrow framing using the lottery question, much like Samuelson's coin flip. What he discovered was that if you allow the subject of the test to have time to think about their personal economic and financial situation before you asked them whether they would like to win twice as much as they might lose, they were more apt to attempt to try the game of chance. He wrote: "attitudes towards regret and reliance on intuition rather than reasoning are likely to drive the tendency to frame choices narrowly."

In their book "The Routines of Decision Making" By Tilmann Betsch and Susanne Haberstroh, the authors suggest that the more routine a decision is - such as investing for retirement - the more likely a person was to resist forecasting. In other words, even if the recent economic downturn had been forecasted, and in some instances it was, the person who might be most at risk of losing value in their 401(k) because of out-sized risk or an overabundant share of their portfolio in their company's stock, might have ignored what was obviously a warning. The markets had routinely ascended along with the value of the portfolio and they had seen this as a reoccurring event that probably would not end in the foreseeable future.

This problem is best manifested in the doctor's office. Your physician gives you news about your health that you are skeptical about or might be life-altering depending on your decision. How do you decide how many second or third opinions you garner to help you decide? Suppose those decisions don't jive with how you are feeling?

Next up: Anchoring

Why Investors Do What They Do

A recent report done by Dalbar, inc. of Boston suggests that investors often do things that hurt what they are attempting to do in numerous ways. Using information aggregated from the Investment Company Institute (ICI.org, a company that tracks and support the mutual fund industry), The Standard and Poors Company (the standard bearer of indexes) and Barclays (which publishes an index of bonds), the company has found that there are numerous influences, both external and internal, that have an effect on how well a portfolio of mutual funds (or stocks for that matter) perform over the short-term and long-term.

They identify nine areas where investors thought they were right, when they were in fact, ignoring signals that the approach they were taking may have led to, even exacerbated losses rather than gains. The report cites these facts from the study to support these claims:

* For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period.
* Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.
* Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index. This disparity is largely due to the underperformance of managed bond funds caused by mortgage-backed securities.
* With an annual loss of 30% last year, asset allocation fund investors fared better than equity fund investors.

The first of these nine areas, which we will examine over the next nine posts, deals with loss aversion. Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made.

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that "since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones." They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker.

How you frame the argument (in an investor's mind), even if it is the same problem, directly affects how the investor reacts. Frame it negatively, and the reaction often leads to risk taking; frame it positively and the investor will chose a risk averse solution.

The battle between what "would happen" if a decision is reached is often overshadowed by the repeated decision making based on what has already occurred. Economists refer to this as a continuous process suggesting that an investor might become overconfident and that generates irrationality.

Martin J. Pring once said, "For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming." According to a Stanford University Business School paper published in July of 2006, "the principle of loss aversion is not derived from any theory of behavior or more basic psychological principles, but is an ad hoc principle introduced to account for a range of phenomena involving tradeoffs between losses and gains." In other words, most investors seek the status quo.

And to change the status quo, investors need a motive. What happens if those motives are fuzzy or ill-defined? The paper, written by David Gal cited an experiment done by Kivetz and Simonson which "offered diners a reward program in which they could receive a free meal at a dining hall after having paid for a certain number of meals. In a between subject design, they found that sushi lovers would actually prefer a reward program which required the purchase of 10 sandwiches and 10 sushi platters to a program which required only the purchase of the 10 sandwiches. Although the former option was dominated by the latter, sushi lovers perceived a relative advantage in that they would likely have eaten the sushi anyway. Based on this relative advantage, sushi lovers inferred that they were getting a "bargain" in an absolute sense."

When information is fuzzy though, it is difficult to determine what the status quo actually is. If you were offered a 50% chance of losing $100 or a 50% chance of winning a $100, the trade-off might seem relatively straightforward. The better bet is to not take the bet at all. What is needed although is a clear preference of what the status quo is.

Loss Aversion does exist but it is difficult to define and hard to expect. Studies have shown that historical data (past performance indicators) often lead us to make these decisions and yet, that same historical data may have little to do with what we may gain, or lose.

Next up: Narrow Framing of Investment Decisions

Retirement Planning and the Rebalance

(Author’s note: This topic will be discussed at length in the book I am currently working on, Mutual Funds for the Utterly Confused, scheduled for a January 2009 publication. You can look for updates on the book at Mutual Funds – Explained as it is written and edited.)

There are some really smart people out there asking some really intelligent questions. Jie (Jay) Cai is one of them. He is currently Assistant Professor at Drexel University in the Department of Finance at the LeBow College of Business in Philadelphia, Pennsylvania. The work he does, while often academic, touches on some of the thoughts that the average investor might have in the course of making decisions about whether to invest in this fund or that one.



The subject of rebalancing comes up often. As investors age, they are often advised to rebalance their individual portfolios to avoid unnecessary risk or exposure for a market that might be too volatile – a suggestion seems better suited for another era. If the argument for retirement savings is based on the fact, as we discuss in the book, that we have not saved enough, then why are we acting as if we did and rebalancing our portfolios.



Mr. Cai along with another very bright fellow, Todd Houge (The University of Iowa, Henry B. Tippie College of Business, Department of Finance) took a long look at the effects of rebalancing inside an index. What they discovered might be considered enlightening.

Before we move on too far, just a brief reminder of what an index does. It is meant to extract a certain group of stocks from the market because of some type of criteria. The S&P 500, an index that is managed by the Standard and Poors Company, keeps track of the largest 500 companies based on market capitalization (or worth – shares outstanding multiplied by the price of those shares). Numerous companies do this to help investor get an idea of how the market is performing based upon just such a grouping. Only the Dow Jones Industrial Average is price-weighted.



Cai and Houge focused their efforts on the index most commonly used to track smaller sized companies, the Russell 2000. Unlike the S&P 500, which actually has 500 companies in its index and among them, the best performing rarely get removed; a small-cap index does not carry the whole of the small-cap universe. They simply can’t.

The reason is simple. Many of the companies in this type of index are too small, rarely traded and considered illiquid. If the Russell 2000 suddenly shifted its balance, all of the funds that track that index would need to purchase the new shares of the latest addition while selling the shares of the latest deletion. This could have not only a negative effect on the share price, but would, in some cases punish the funds who need to buy those companies but are unable to find an adequate amount of shares in the marketplace.



But suppose you didn’t sell the shares of the companies kicked to the proverbial curb. According to the two men, “a value-weighted portfolio of index deletions return an average of 1.52% per month compared to only 0.87% for non-new issue index additions.” This continues for the next five years although the gap does narrow somewhat.

More so in the next book than this one, I talk about how and why actively managed mutual funds choose a certain index. Some are actually trying to mimic the index while some are trading the same companies held within the index. It would be hardly fair to compare a small-cap growth fund with the largest names on Wall Street.

Here’s the problem. Index funds have their place in a retirement portfolio and, it is not inside your retirement account. (Buy the book to find out why. If you already own the book, you know why.) Actively managed funds that look to compare themselves to an index, do so to attract investors to their performance. Trouble is, too many actively managed funds do not practice a buy and hold strategy.

What Cai and Houge discovered suggests that if fund managers do try and mimic an index, they may be leaving money on the table so to speak. If they continued to hold the deleted stocks from the index, they would do better than if they had tried to follow the index too closely.

And how can you follow the Russell 2000 too closely. The index, according to the authors of the paper changes on a certain day each year and unlike many of the other indexes is not based on some “proprietary selection process.” In choosing the Russell 2000 to track, they stumbled onto an index that changes shape often and sometimes in a huge way.

“Russell replaces an average of 457 firms or nearly 23% of the index holdings each year. The annual turnover ranges,” they wrote “from a low of 309 companies in 1980 to a high of 690 companies in 2000. Since delisted securities are not replaced between reconstitution dates, the number of additions always exceeds the number of deletions.”

The person focused on retirement planning can draw two conclusions from this. First, not all indexes are created equal, necessarily do as you would suspect and might be more active than you would imagine.



The second is much simpler. Indexes often bill themselves as safe havens for investors and some might be safer than others, but the performance numbers they use in their sale material might not be as good as an actively managed fund that acts passively. Turnover may become the key statistic in determining the overall long-term strength of a mutual fund.

You can read the full paper, titled “Index Rebalancing and Long-Term Portfolio Performance” here or download the PDF

Retirement Planning and Dennis Connor

Numerous people turn to books written by the highly successful among us trying to mine some keys to what makes them what they are, try to understand how they achieved what they have succeeded in doing and perhaps, take what they might be able to tell us and apply it to our daily struggles. This does not always mean, that just because you read one winner’s book, that you can become a winner as well. Emulation is no easy feat.



I threw a quote from renowned skipper and yachtsman Dennis Conner in the book as we begin the section on investing as an “Early Bird”, a title I give to the investor just beginning her or his journey. Mr. Conner won the America’s Cup four times, first in 1974, then again in 1980, 1987 and finally in 1988.



Now this race, won by Americans – super wealthy Americans I might add – for 132 years in a row, captured the imagination of the average citizen because, unlike previous challenges, Dennis Conner insisted on year round training of his crew. Prior to this, the challenge, which was offered as a goodwill gesture among nations, was the playground of the super rich. That winning streak was the longest in sports history (which Conner had the distinction of breaking when he lost in 1983 to Alan Bond of Australia).

Connor’s approach to the sport was based on what he liken to consistency rather than flash or brilliance. This is the cornerstone of what retirement planning should be even if you are just beginning to save. There are some schools of thought that suggest all out risk taking for the most youthful investor trying to build a retirement portfolio. I disagree.



There is a psychological element to losing that not all beginning investors share. There is the chance that once an investor feels the sting of an investment downturn, they might not see it for the opportunity that it presents. More than one financial writer, myself included, has suggested that starting young (in their twenties) will provide over twice the investing opportunities than if they waited until they were in their thirties. Compounding provides some of that proof. The other is given to investors via the markets.

No one can predict what the markets will do from day-to-day and it becomes even more difficult as you look at a month-to-month or quarter-to-quarter snapshot. What does become clear though is how the chance of your investment increases over longer time spans. But not many twenty year olds can see very far into the future.



Connor did write a book about his successes called the Art of Winning. In it he outlines what could be considered no-brainer ideas that have been repeated numerous times over numerous books. He suggests that attitude (envisioning success) performance (seeking to learn from the best in your field), teamwork (surrounding yourself with competent people who share your goals), competition (nothing like a little challenge to help you on the road to self improvement), and goals (knowing what you are capable of and how you plan on getting there) all play a role in who wins and who does not.

Retirement Planning and Speculation

Once you understand the way risk and reward operate – or better, how more risk might mean more reward, the tendency is to assume more risk is almost too tempting to avoid. This is often done, in many cases with the full knowledge that increased risk does not always result in increased reward. In other words, once you grasp the seductive power of increased risk, many investors choose to discount the downside of the equation. This can be incredibly dangerous when it comes to your retirement portfolio.

Consider the word speculation. Speculation (spek'yuh-LAY'shuhn) n. has several definitions. The first is the act of speculating or the contemplation of a profound nature, a conclusion, opinion, or theory reached by speculating. We think therefore we speculate.



The second definition is much more dangerous. It involves the engagement in risky business transactions on the chance of quick or considerable profit. Jacob Freifeld’s 1996 paper on the subject of behavioral decision making titled “Speculative Bubbles: Financial Genius Before the Fall" came well in advance of what was to be, at least until the sub-prime mortgage mess began to unfold recently, the greatest market bubble of in recent history.

He wrote about the theory of speculation: “In some cases this financial innovation is replaced by changes in government policy that either favor easy credit or lower taxation, stimulating rapid business growth. Whatever the case may be, a financial atmosphere of tremendous supply combined with demand for some desirable asset, be it stocks, real estate, or even rare tulips, gives birth to the speculative bubble.”

Many financial writers, myself included have alluded to the lessons of the tulip. Tulips became the craze of the wealthy in the early 1600’s, so much so, that if a person of means did not own a collection of these rare flowers, they were considered uncultured. The demand for these exotic bulbs grew into speculative and historic proportions.




Charles Mackay, in his book “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds” published first in 1841 wrote: “The demand for tulips of a rare species increased so much in the year 1636, that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns. Symptoms of gambling now became, for the first time, apparent.”

There is, however no place for speculation in your retirement plan. The fact that they exist at all, is the largest hurdle any investor, especially one interested in building his portfolio for retirement, has to face. As I mentioned previously, the presence of a bubble or the effects of its aftermath tend to leave many investors indecisive.

Even as he wrote his paper, he wondered about the state of the stock market. “Currently the U.S. stock markets are in the late stages of what looks like a speculative bubble.”



While I go into great detail (in the book) about what is important to consider when bubbles exists, and how to invest your way through them, folks like Mr. Freifeld will sound warning bells well in advance of the impending disaster. But it is something you can ignore.

If your retirement planning is based on a conservative approach, a common sense approach if you will that rises above speculation, you will have no need to pay heed to those warnings. Believe it or not, you can win in any market situation.