Rethinking your
401(K)
and
Other Personal Investment Strategies
By Allyson Lewis
From January 1, 1991 through
December 31, 2001, the S&P; 500 generated an average annual return
of 12.93% and the NASDAQ posted 12.77%. Conversely, if you look at the
three year period from January 1, 1999 through December 31, 2001, the
S&P; 500 generated an average annual return of -1.03% and the NASDAQ
posted a dismal -3.83%.
Many investors are asking, "Why is
my 401(k) worth the same amount it was at the end of 1998? What happened
to the last three years?"
Let's first look at the math. Just to
make life easy assume you had accumulated $100,000 in your 401(k) by
the end of 1998 and that you were investing in the S & P 500 Index.
1998 year-end
value $100,000
1999 +21.04% year-end
value $121,040
2000 -9.10%
year-end value
$109,998
2001 -11.88% year-end
value $
96,930
Investing in the S&P; 500 was kind
of a best-case scenario for long term stock investors. However, many
of you reading this article may have had a healthy portion of your 401(k)
held in growth mutual funds that more closely mirrored the NASDAQ Composite
Index. For comparison, using the same information as the above illustration,
the following shows how a $100,000 investment in the NASDAQ Composite
would have performed over the last three years:
1998 year-end
value $100,000
1999 +85.59% year-end
value $185,590
2000 -39.29% year-end
value $112,672
2001 -21.05% year-end
value $
88,955
The last three years have taught us many
things:
Risk exists.
The pain of losing money has taken many
investors by surprise. From the beginning of the bull market in 1982,
most people thought they could invest in the stock market and just wait
for the money to come pouring in. From January 31, 1979 to January 31,
1998, the S&P; 500 compounded at an average annual rate of return
of over 17% per year! With the exception of the 22% decline on Black
Monday in 1987, the corrections were fairly limited and considerably
short in their duration. Investors used the downturns to add to their
positions and they were rewarded time and time again. For the most part,
the last 20 years caused investors to lose sight of the underlying risk
of investing.
The importance of diversification.
Diversification emphasizes the importance
of utilizing proper asset allocation strategies. Asset allocation is
a fancy term describing how investors choose to allocate their financial
assets between the basic asset classes of Cash, Bonds, and Stocks. The
key question you may want to ask yourself now is: "Is my 401(k)
properly allocated into the correct blend of cash investments, bond
investments and stock Investments?" And further, "Within the
stock category, am I investing in the appropriate types of growth assets
for my age and risk tolerance?"
Begin with quality.
Quality investments should build the foundation
of all investment strategies. This is true whether you are talking about
building your personal portfolio or your 401(k) plan.
Compound Interest
time is on your side.
The best time to start investing is with
your very first paycheck. If you can begin to save 10% of your pre-tax
income from the beginning of your career, you should be able to accumulate
a large enough nest egg to help plan for your financial future. This
again takes us back to one of the most significant benefits of your
401(k) plan‹the fact that once you have signed up, your money is
automatically withdrawn from your paycheck and placed into an investment
account that is designed to be left alone until you are at least 59.
The final responsibility
is yours.
The last three years have caused many
long-term investors to rethink their investment strategies. In the future,
it may no longer be as simple as putting your retirement dollars into
a retirement plan without thoroughly understanding all of your available
investment options. EDUCATION will play a much larger role in many people's
investment strategy. Raising the bar on your own personal understanding
of your investment options could dramatically impact the future performance
of your retirement plans.
The question then becomes what do I do now?
STEP 1
Reassess your personal risk tolerance level.
Defining your personal risk tolerance
level will allow you to build a portfolio that is the most suited to
help you reach your future financial goals while allowing you to invest
within your comfort zone. This short questionnaire may offer some insight
into your personal feelings toward risk. It will also rank some of the
common factors that determine your ability to take on risk. These factors
include age, income, current savings and general investment knowledge.
1. What is your age?
1. 65 and over
3. 36-64
5. 35 and under
2. What is your investment time horizon for this money?
1. 1 year
2. 2-5 years
3. 5-10 years
4. 10-20 years
5. 20 years or longer
3. What is your primary objective for this money?
1. Safety of Principal
2. Current Income
3. Growth and Income
4. Conservative Growth
5. Aggressive Growth
4. Regarding your income, do you expect it to:
1. Decrease dramatically in the future
2. Decrease a slight amount in the future
3. Stay about the same
4. Increase with the pace of inflation
5. Increase dramatically
5. What amount of money do you have set aside for emergencies?
1. None
3. Enough to cover three months of expenses
5. Enough to cover six or more months of expenses
6. Which statement best describes your personal investment experience?
1. I have never been responsible for investing any
money.
2. I am relatively new investor.
3. I have invested some of my money through IRAs and
through employer sponsored retirement plans (401
(k)) for quite some time, but now I am ready to develop additional investment
strategies.
4. I have invested for quite some time and am fairly
confident in my ability to make prudent investment decisions.
5. I have invested money for years and have a definite
knowledge of how the various stock and bond markets
work.
7. Regarding your view of risk, which investment would you be more comfortable
making?
1. I am comfortable investing in savings accounts
and CDs that are FDIC Insured.
2. I invest in savings accounts and CDs, but I also
own various income-producing bonds and/or bond mutual
funds.
3. I have invested in a broad array of stocks and
bonds and mutual funds, but only the highest quality.
4. I have invested primarily in growth stocks and
growth stock mutual funds.
5. I like to pick out new and emerging growth companies
and aggressive growth stock mutual funds.
8. To understand your risk tolerance level more clearly, which investment
would you be more likely to invest in:
This investment has a 20-year average
annual return of 6%. It has achieved those returns with infrequent and
very slight downturns. This investment has never experienced a negative
return.
This investment has a 20-year average
annual return of 9%. It has achieved those returns with a few moderate
downturns where the decline lasted less than six months and then began
to recover. It has experienced more than one-year of negative returns.
This investment has a 20-year average
annual return of 14%. It has achieved those returns while cycling through
several periods of above average returns and several periods of substantially
negative returns.
What's Your Score?
To score the risk tolerance test simply
add up the points. You will receive one point for each number that you
circled. For example, if you circled a 1, you receive one point. If
you circled a 4, you receive four points. Please count the number of
points you circled and place a star on the risk tolerance scale at right.
These questions and this scoring scale
is meant to be used only as a guide your actual investment plan may
vary based on additional information that was not asked in this questionnaire.
But, after you have scored your risk tolerance level, the next step
will be to create a portfolio of investments that matches your asset
allocation to your risk tolerance level.
The following is a list of some sample asset allocations based on five
basic risk tolerance levels:
1. Ultra
Conservative
Cash 18%
Bonds 67%
Stocks 15%
2. Fairly
Conservative
Cash: 12%
Bonds: 51%
Stocks: 37%
3. Moderate
Cash 5%
Bonds 38%
Stocks 57%
4. Fairly
Aggressive
Cash 3%
Bonds 21%
Equity 76%
5. Ultra Aggressive
Cash 0%
Bonds 7%
Stocks 93%
Step 2
Understanding your basic investment options
Cash
For this article, we will define a cash
investment as anything that carries a maturity date of less than 12
months. Therefore the most common cash investments would include:
Checking accounts
Savings accounts
Money market accounts
And short-term CDs
The advantage of Cash investments is
their safety and their liquidity. The disadvantage is their low return.
Bonds
Bonds are also known as fixed income investments.
Bonds give you the opportunity to put a specific amount of money into
an investment, receive a specific and usually dependable return, and
then get your original investment back on a specific future date.
There are several bond strategies available for a 401(k) investor:
Short-term
strategy short-term bonds will mature in less than
five years. They carry the lowest yields and the smallest amount of
principal fluctuation. Risk averse investors may want to buy high quality
short-term bonds.
Intermediate
strategy intermediate bonds offer maturities from five
to ten years in length. These bonds should give you a somewhat higher
yield that a similar short-term bond, but because of their extended
maturity dates, they have more volatile price fluctuations.
Long-term
strategy long-term bonds vary in length from 10 to
30 years. They often pay an even higher rate of return than an intermediate
bond, but because of their length, they have the most price volatility.
Stocks
Stocks have historically been the favored
asset class for long-term investors who have the time and the appropriate
risk tolerance level to ride out the volatility inherent in the stock
market. But, as the market place has become more and more sophisticated,
an ever-longer list of choices may have been added to your 401(k) plan.
Here are some of the more common growth investment options.
Standard and Poor's 500
stock index
It is one of the most widely followed
stock benchmarks. This index dates back to 1923 and currently includes
500 stocks from 83 industries. It is often thought of as the "if
you can't beat 'em, join 'em" investment strategy.
Large Cap Growth Stocks
Also known as large caps. Some investment
analysts consider a company with a market capitalization of over $2
billion to be a large cap stock. These companies are often well known
stocks and are referred to as blue chip stocks. These stocks are growth
oriented and are often in the fastest-growing industries. Industries
might include technology, health care, telecommunications and some financials.
Large Cap Value Stocks
Are known as large caps as well, but they
are very different from the growth stocks we just described. These companies
are very large and well known but they tend to come from the older,
"boring" industries like, transportation, energy, utilities
and consumer cyclicals.
It is important to understand the vast
difference between growth stocks and value stocks. They can both play
a role in helping you reach your future financial goals, but they often
rotate in and out of favor. For example, when growth stocks are in vogue,
value stocks may underperform and then growth may move into a period
of underperformance while the old time value stocks reclaim the limelight.
Unfortunately, many investors will get caught in the trap of trying
to chase the hot investment of the moment and they will see that growth
stocks have been outperforming for the last two years, so they will
sell off all of their value stocks and move that money into the growth
sector only to find that now growth is beginning to fizzle out and value
is coming back into favor. Economists and analysts will fight until
the end of time trying to tell you exactly what you should be buying.
A better strategy may be to buy some of both growth and value stocks
and let the cycles rotate over time.
Mid Cap Growth and Value
Stocks
Mid cap stocks refer to companies with
a market capitalization from $500 million to $2 billion. These companies
are usually not as well known but may offer a more aggressive growth
potential. Please be aware that mid cap growth stocks and mid cap value
stocks also act in very different manners and will perform differently
under certain economic conditions.
Small Cap Growth and Value
Stocks
Small cap stocks refer to companies with
a market capitalization of less than $500 million. They are even less
likely to be known by the average investor, but history has shown that
this asset class has generated the largest returns since 1926, albeit
with a higher degree of risk.
Balanced Funds
A balanced investment seeks to invest
in all three major asset categories cash, bonds, and stocks. Different
managers use different strategies for achieving adequate returns while
attempting to reduce risk by having some exposure to less risky assets
like cash and bonds.
International Funds
The world is a very large place with investment opportunities at every
corner. If you limit yourself to stocks in the United States, you are
missing out on over 50 percent of investment opportunities. International
investing can also serve as a hedge against difficult periods in the
US stock markets.
Risk of the various indexes
as measured by standard deviation.
The higher the deviation, the higher the
risk. It's time to quit hoping for a quick recovery in the stock market,
which may or may not happen in time to help rebuild your retirement
plan, and it is time to develop an investment strategy. You need "A
PROCESS" for achieving your goals and dreams that is less reliant
on the probability of an unknown return in a specific market, and one
that is more related to answering some very basic questions and then
designing a WRITTEN FINANCIAL PLAN to take you there.
The bottom line is that you need to fully
understand your own risk tolerance level and then design a long-term
asset allocation strategy that will allow you to think long-term. Understanding
your personal investment options could be one of the keys to your success.
Portions of this article
were excerpted with permission from the author, The Million Dollar Car
and $250,000 Pizza (Dearborn, 2000).
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