One of My Favorite “New” Features of 401(k) Plans
September 16, 2011I would love to write about my favorite flavor of ice cream (Ben & Jerry’s Karmel Sutra) or other favorite foods (too many to list, which is why it would be fun to write about it), but I’m having trouble finding a way to make a connection into the financial world. I just got done watching the Food Network’s “Best Thing I Ever Ate,” so forgive me for the food references. While watching that, I happened to be reading an article in a financial journal at the same time (is that multi-tasking or A.D.D.?) about features that are available today in 401(k) plans that weren’t widely available 10 years ago. They listed things like auto-enrollment and a cap on the percentage of company stock allowed in the plan, as well as a few others. The one that really stood out to me as something that, if I could wave a magic wand and get everyone to enroll in I’d do it in a second, is the automatic rebalancing feature. Why do I like this feature so much? Well, I’ve seen it work as a means of managing your investment risk. I’ll use an example to illustrate my point.
Remember the dot-com crash in 2000? I do. At the time, I had been working as a financial planner for a brokerage firm and many of our brokers would introduce me to their clients to help them develop long term financial plans. A portion of those plans dealt with their investment strategy. In the great stock market of the mid-late 90’s, we all saw stock market returns soar. I met with people who had initially invested 10-20% of their assets in small companies’ (like dot-coms) stock. After a few years of tremendous growth in those technology stocks, that original 10-20% had become 50-60% of their portfolios. Because they were “making money” in those stocks, they didn’t want to consider paring back the allocation. When the bubble burst, many investors suffered dramatic losses. Some weren’t hit quite so hard. One of the people who weathered that storm very well comes to mind. She managed to come out of the 2000-2003 bear market without sustaining any losses. From the start of the drop till the start of the recovery, her return was in between 0 and 1%. Not exactly spectacular, but not a loss, either! In that market, that was a very good thing.
She was a true believer that all investments are cyclical. They go up; they go down, back up again and back down again. Repeatedly. But, she didn’t know when those cycles would start or stop, so she developed a strategy with her financial team. She figured that the best way to make money in the investment markets (stock and bond markets, her overall portfolio consisted of 50% of each) was very simple. “It’s not that difficult, gentlemen. All you have to do is buy low and sell high” is what she would tell us at each meeting. So, we developed a “process” to do just such a thing. It was a simple rebalancing strategy. If her Small Cap stock position (or any position) went from 10% to 20% of her portfolio (because the prices went up, so that satisfies her “sell high” criteria), a portion of that investment would be sold to get back to her 10% target. The money from that sale would then go to another investment (Bonds, Money Market, maybe International stocks) that had declined in value (satisfying her “buy low” criteria). We put guidelines in place and began an automatic rebalancing program for her. All of this happened during the rising stock market of ’95-’99. Did she give up some of the absolutely remarkable gains when the dot-coms were doubling in price almost monthly? Sure. But, it kept her investments in line with her investment philosophy. But, how did it do in a down market?
We got to see those results up close and personal during the bear market of ’00-’03, and it was a good thing. She didn’t lose money during that downturn. A part of the reason for that was the rebalancing. Nothing in her portfolio was allowed to grow so big during the good times that, when the cycle shifted to bad times, a downturn would create catastrophic results. Her portfolio was routinely brought into line with her goals by the rebalancing program. At the time (this was 15+ years ago), rebalancing wasn’t very popular but it made sense to her, and to me as one of her advisors. With her as a model, we developed a rebalancing program that was used on many clients. It was never designed as a way to maximize investment returns; it was designed to help reduce investment risk. And it worked. In the years that have passed, rebalancing has become more automated and more widely used. And, for many of you it’s available in your 401(k) plan.
I’ve seen rebalancing work for people and am delighted to see it in wide use today as a tool in 401(k) plans. It helps take the emotions out of investing, and that’s where many of us get into trouble and make mistakes. Human nature has us wanting to add money to the part of our portfolio that just doubled (hey, why not, it’s a winner!) and pull money from the part that just dropped by 40% (that happened a lot in 2008, “get those stocks out of my account, it’s killing me!”). But, doing that would be a “buy high, sell low” philosophy. Last time I checked, that’s not the greatest idea ever. When we have an investment strategy, stick to it, and have it automated, there is a much lower likelihood that we will make an emotional decision and mess up our long term plans. Rebalancing takes care of a lot of this for us.
That’s why I’m a big fan of rebalancing features in 401(k)s. If you want to know why I’m a big fan of Ben & Jerry’s Karmel Sutra, just try it! And, while you’re trying it, sign up for your 401(k)’s rebalancing feature.