An Unnecessary Gamble: The Biggest Mistake in Retirement Investing

One of the most common mistakes made in the retirement investing world, particularly among 401(k) participants, is over-concentration in an employer's stock. In an analysis of more than 100,000 401(k) participants from companies offering stock in their 401(k) plan, more than 54 percent of employees had stock concentration levels that were greater than 20 percent of their total account, an amount that is enough to significantly decrease their median forecasts. In fact, loading up on your employer stock is even worse than loading up on a random individual security. Why? Because chances are your job (and hence your future income) is likely to be highly correlated with how the company stock performs. If bad things happen to the industry or the stock of your employer, you are likely not only to lose your money on the investment, but possibly your job as well. As the unhappy former employees of Enron can attest, this double whammy effect can be devastating, particularly if you are nearing retirement. This implies that you should be even less likely to want to hold the stock of your employer than you would be to hold the stock of a random company. Unfortunately, surveys suggest that many employees do exactly the opposite, loading up on their employer stock in their retirement plan.

People often confuse a good company with a good stock. Your company may be the most amazing, creative, world-dominating, run-by-geniuses firm around, but that does not mean that the stock is undervalued. Chances are, all that good stuff about the company is already factored into its price by the market. To determine that something is undervalued, you have to have information about the future prospects of the firm that are not understood by the market. If it is public, you can bet that the markets have already digested the information. If the new information is private, you are prohibited by law from trading on it (this is called insider information). Never make the mistake of assuming that a great company implies a great stock.

Sometimes the impact of stock volatility can be counterintuitive. Consider an investor at the beginning of January in 1997. Let's say this investor consulted a magical genie and was offered a stock pick that would return an average of 37 percent per year for the next six years guaranteed. The genie states that there would be many bumps along the road, but the investment was guaranteed to have average annual returns of 37 percent. The investor does a quick calculation in his head and determines that if he invests $100,000 in the stock and gets an average annual return of 37 percent, then he stands to make about $560,000 over the next six years. Not a bad deal, right? Sure, there will be some volatility, but those guaranteed average annual returns look pretty good. The investor thanks the genie and promptly goes off to invest his $100,000 in the recommended stock.

Fast forward six years later to December 31, 2002. As promised by the genie, the stock pick has achieved annual returns of 37 percent over the six-year period. But the investor is astonished to see that his account balance is only $80,130. He actually lost 20 percent of his money! What the heck happened?

The stock in this example (JDS Uniphase Corp.) actually did have average annual returns of 37 percent over the period January 1, 1997, through December 31, 2002. But the growth rate (which takes into account the impact of the volatility) was an anemic -3.6 percent per year. The average return was pretty good, but the volatility of the stock's performance killed the growth rate.

The stock had extraordinary performance in the period leading up to early 2000, but this was matched by equally poor performance in 2001 and 2002. The result was that average returns were strongly positive for the six year period, but the overall cumulative performance was poor. This is an extreme example, but clearly demonstrates the danger of focusing too much attention on average returns without considering the impact of volatility. Remember that volatility matters a lot in accumulating wealth over time.

The above is an excerpt from the book The Intelligent Portfolio by Christopher L. Jones Published by John Wiley & Sons, Inc.; May 2008;$27.95US/$30.99CAN; 978-0-470-22804-3 Copyright © 2008 Christopher L. Jones

Author Bio: Christopher L. Jones is Chief Investment Officer and Executive Vice President of Investment Management for Financial Engines. Working closely with founder William F. Sharpe, Jones built and led the team of experts in finance, economics, and mathematics that developed the financial methodology for Financial Engines' personalized investment advice and management services. Jones has led the investment management function at Financial Engines for more than a decade. He holds an MS in business technology, an MS in engineering-economic systems, and a BA in quantitative economics, all from Stanford University.

Where's The Beef?: Getting the Financial Advice You Paid For

There's nothing better than a hot and juicy steak, especially one from your own grill. But, can you imagine going to the grocery store to pick up a few prime ribs, only to get home and realize you ended up with cube steak instead? Talk about injustice! Of course, this doesn't happen to most of us, because grocery stores package their meat in clear plastic wrap, so we can see exactly what we're buying. If only we bought financial services the same way.

True transparency is sorely lacking in an industry that packages itself with imposing-sounding credentials, slick advertising and carefully orchestrated seminars. Many investors are convinced they are receiving the "prime rib" service they're paying for, without realizing all they're getting is some chewy cube steak.

That was the case with "Bill," an investor I talked with recently. Bill had two million dollars in investable assets and was using a number of different advisor services to manage his wealth. Some of them were commission-based while one was fee-based. But, all of them were using mutual funds exclusively, and none of them were aware of Bill's total financial picture.

The firms that Bill was using were very professional sounding and had nice offices. Their credentials were good and they were obviously successful (at least in gathering new clients). Each had convinced Bill to trust them with hundreds of thousands of his hard-earned dollars and invest in their "unique" strategies.

The problem was their strategies weren't that unique. They were basically just splitting Bill's money between different mutual funds. One commissioned advisor convinced Bill to also use a timing service to get in and out of the mutual funds he had at his firm. Bill had to pay dearly, with a 3% commission on the initial investment, then an additional 2% a year just for the timing service.

The other advisors' fees weren't much better. One, a local franchise of a national mutual fund supplier, charged 1% per year. But all they had done was help Bill with the initial fund selection. They hadn't made any adjustments since, even though the markets had dramatically changed in the mean time.

To make matters worse, some of the advisors had Bill in the exact same funds. He should have paid a reduced or no commission on the some of the mutual funds he was buying. But, because the right hand didn't know what the left hand was doing, Bill wasn't given the advantage of the breakpoints he was entitled to.

All of Bill's advisors had one thing in common: sub-par performance. When you add up all the fees and commissions, including each fund's underlying internal management fees, Bill was paying 'prime rib' prices of 3% to 4% a year, and only receiving below average returns and cube steak service from his advisors. They weren't managing Bill's money. They were of the "set it and forget it" mentality. And Bill's wealth suffered as a result.

The same can be said about another investor I know. "Sam" had his money with a very large national investment firm. Sam was very impressed with the slick sales material they sent him, including a "free," and very professional, DVD. The salesman that followed up with a phone call was very persuasive, and Sam was glad to be investing his money was such a large and prestigious firm. Sam also liked that they were fee-based and he didn't have to pay any commissions.

Sam was promised customized strategies with superior results. But over time, he realized the performance he had hoped for wasn't materializing. He was paying 1.5% a year for average performance. His money wasn't being individually managed as initially promised, but lumped in a group with everyone else. At the beginning, Sam thought investing in a firm with $40 billion in assets was a good move. But in the end, he realized that he was getting lost in the shuffle and his nest egg was being put on ice.

These stories are not unique. The majority of investors are overpaying and receiving below-average performance and service. Next week I'll show you the right questions you must ask any potential advisor so you can get beyond the packaging and find out exactly what kind of steak they are really selling.

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