From the Desk of David Gratke

Archive for the ‘401(k)’ Category

Individual Investors, ‘Behavior-ing’ Badly; Continuing to Buy High, Sell Low

Thursday, June 24th, 2010

Well, how do I say this? Individuals, as a group of investors, are the worst class of investor that exist. Sorry. I would certainly like to ’sugar coat’ this topic with sprinkles but the multi-decade long studies of Investor Behavior created by DALBAR has the data in my favor allowing me to make such a statement.

Dalbar creates what is called the Quantitative Analysis of Investor Behavior (QAIB) study. They have been doing this report for many years. Simply put, over multi-decade time frames, typically two-decade time periods, the investment returns for the individual investor are dismal at best.

Over twenty years, the individual investor cannot keep pace, or even outperform, inflation. The graph below reflects the past twenty years ending in 2009. The average return for investors in stock mutual funds was 2.3%! Inflation outpaced the individual investor at 2.8%. Investors constantly ‘obsess’ with the idea of outperforming the market. The market (as measured by the S&P 500 Index) has returned 8.2% annually over the past twenty years. Individual investors cannot come close. So this ongoing conversation about finding investments that outperform the market, how about just getting to the market returns before worrying about beating them?

(Above Graph disclosures: The indexes used are as follows: REITS: NAREIT Equity REIT Index, EAFE: MSCI EAFE, Oil: WTI Index, Bonds: Barclays Capital U.S. Aggregate Index, Homes: median sales price of existing single-family homes, Gold: USD/troy oz, Inflation: CPI. Average asset allocation investor return is based on an analysis by Dalbar Inc. which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. All returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/09 to match Dalbar’s most recent analysis.)

Another way to look at this topic is in the flow of money into, and out of, mutual funds. Again, the story is one of emotion. Buy at the top, and sell at the bottom. My four minute video on YouTube titled Investor Emotions would be a good primer for the reader, and how I have created a process to greatly reduce, hopefully eliminate, investor emotion.

As we all now know, 2009 was one the most explosive stock market rallies in recent history; second only to returns generated in the 1930s. Everyone ‘caught’ this 2008-2009 rally right? Everyone ’stayed the course’ or even purchased more stocks for this once in a lifetime stock market rally? Right? Well no, ‘NOT EXACTLY’ as the quote goes. Look at the 2009 ‘flow of funds’ for mutual funds. It tells a much different story.

A record $306 billion went into taxable bond funds while investors withdrew net -$9 billion from equity mutual funds. Interest rates are at historic lows, and as we know, bond values have an inverse relationship to those of interest rates. Over time, rates will go up, and when interest rates do go up, bonds will lose value. So not only did the individual investor miss the greatest stock market rally in their adult lives during 2008-2009 when they sold stocks, they bought bonds at the top of the bond market as well.

Investors need to sell greed and buy fear, not the opposite.

Mutual Fund Flows. Note the poor investment choices individual investors made in 2009. Nothing has changed with respect to investor behavior, investor emotions; buy high, sell low. Investors sold stocks (at the bottom) in 2008 and 2009 and purchased bonds (at the top) in 2009 as illustrated below.

The graph below, from Bessemer Trust, reflects investor buying ‘habits’ ten years apart. Stock purchases at the market tops beginning in 1999 and bond purchases at the market tops beginning in 2009. Ten year differential, different asset classes, same result, buying asset classes at the high.

The slide below also reflects how individual investor returns pale when compared to institutional investor returns such as those for foundations, endowments and corporate and public pension plans. Why is this you ask? Simple, institutions have an investment process for investing their funds; they do not use emotion. Process works, emotion does not. Let me reiterate, “My four minute video on YouTube titled Investor Emotions would be a good primer for the reader, and how I have created a process to greatly reduce, hopefully eliminate, investor emotion.”

(Admittedly, the chart above is dated, but investment process, over emotion, is what creates the performance differential-that’s the take-away in the chart above)

“The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it (time the market) successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently”

- John Bogle, founder of Vanguard Investments (source here)

There are two types of returns

Due to the behavior of individual investors, buying high, selling low, there are actually two types of returns, “Investment Return” and “Investor Return“. Investment return is the actual return of the investment on a calendar year basis; say that of any mutual fund from January 1st to December 31st as measured by the change in the ‘net asset value’ (NAV) of the fund. Then there are the investor returns, based upon the individual’s personal purchase dates and sale dates (cash flows); Again, it is usually that of buying high, selling low as we just read in the above 2009 flow of funds information.

The difference between these two returns is called the “Behavior Gap”. A good financial advisor worth his/her salt knows this and manages around it. OK? Someday I should print new business cards with the title, “Behavior Modification Specialist”, and you laugh……

Chart Source: http://www.behaviorgap.com

Conclusion; Retiring with Dignity, can it still Happen?

If you, the reader, are an employer you may be asking yourself, what liability do I have for my employees within our 401(k) plan based upon these investment results and these investor behaviors? Well, 55% of all mutual fund assets (as of 2009) were held inside qualified retirement plans, so yes this data does affect you, your employees and your fiduciary responsibilities as a plan sponsor. You may wish to read about my philosophy on the state of the 401(k) plan arena below.

http://www.davidgratke.com/401K.html

David Gratke Wealth Advisors, LLC (DGWA) recognizes there are fundamental flaws within the traditional 401(k) retirement plan. When 401(k)’s started in 1978 when Congress amended the IRS code, this would change retirement plans unlike before. Prior to 1978, retirement (pension) plans were principally managed by professional investment managers. The 401(k) did just the opposite; it required participants to direct their own investment decisions, thus creating what might be called the ‘accidental investor’. For the most part, the accidental investor does not want the task, duty or responsibility of directing his or her own investments decisions. They are ill equipped as investor behavior studies bear this out. As a result, we at DGWA believe the traditional ‘do-it-yourself’ 401(k) plan is fundamentally flawed in three ways.

Plan Underperformance
Personal Liability for Sponsors
Complicated Administrative Burden

DGWA has teamed up with other innovative industry professionals to deliver solutions, which once implemented, lead to improved plan performance, reduction of sponsor liability and a simplified process overall. Let us review your plan with look at plan performance, plan costs, success of your employee education program and lastly, your fiduciary liability. From there, let us offer a strong recommendation where needed in order to redirect your plan’s resources in a more purposeful, productive fashion.

Contact David Gratke now to review your 401(k) plan

Thank you for reading.

Posted in 401(k), Accidental Investor, Behavior Gap, DALBAR, Emotions, Investment Process, Investor Behavior, Investor Fear, Missing the Market, Past Performance, Weak Hands Strong Hands | No Comments »

Target Date Fund Are all Created Equal, Right?

Thursday, July 16th, 2009

‘Not exactly’

In recent years, target date funds have exploded in popularity. These funds were created primarily to manage risk and create simplicity for employees participating inside of employer sponsored 401(k) retirement savings plans. The principal concept behind target date funds is that risk should be lower for investors as they get closer to retirement. This objective is implemented by changing the asset mix of stocks and bonds, since the underlying principle is that when one approaches retirement, the portfolio should have an increasingly conservative allocation of assets.

Until now, many have viewed target date funds as a homogeneous style of investment; that all target-date funds of the same retirement date (i.e. 2010) are similar regardless of vendor. Most employers and employees probably have come to a similar conclusion.

However, target date funds are not created equal – as we saw in 2008, when many experienced very poor performance, as seen in the following press accounts.

Financial Planning magazine, February 2009: “More warts have been laid bare after last year’s market meltdown. For instance, depending on which 2010 fund they were in, an investor looking to retire next year could have lost as little as 4 percent in 2008 or as much as 41 percent. One reason for those widely varying returns: The stock components of the 2010 funds that Sen. Herb Kohl’s Senate Special Committee on Aging recently studied ranged from 8 percent to 68 percent.”

Investment Advisor Magazine, March 2009: “Target date funds, on average, were down 25% last year, with 2010 funds dropping 25% to 30%. Attorney Fred Reish of Reish Luftman Reicher & Cohen in Los Angeles, which specializes in employee benefits law, says that given the poor performance of target date funds, advisors need to be “talking with plan sponsors much more about their target date funds, how they performed last year, and see if that’s what the plan sponsor wants.”

The Associated Press, May 17, 2009: “Target-date mutual funds are supposed to simplify investment planning by automatically dialing down risk as you approach the day when you can finally call yourself retired. Yet the recent market meltdown exposed how funds with the same target date can yield wildly different results. For investors with the freedom to pick among the more than 40 companies now offering target-date products, good luck. The asset mixes in funds that attempt to ease you toward the same retirement date vary so widely that they defy simple apple-to-apple comparisons. Plus there’s a lack of easy-to-use tools to see how one fund stacks up against the next.”

The New York Times, June 24, 2009: “Washington blessed them as a way to put your 401(k) on automatic pilot and glide safely toward retirement. But popular target-date mutual funds have badly missed the mark — and now regulators are asking why. Labor Department officials evidently found the concept persuasive. In 2007, they issued an unusual rule that protects employers who automatically send workers’ 401(k) money to target funds if, later, the employees lose money. That so-called safe harbor unleashed a flood of money into the funds. But as the stock market plummeted last year, some 2010 funds — which many investors thought would be invested safely by then to protect their nest eggs — lost 40 percent of their value. That showing was even worse than that of the Standard & Poor’s 500, which fell 38.5 percent.

The Wall Street Journal, July 4, 2009: “Given the dramatic, wealth-killing market Crash of 2008, it’s not surprising that target-date funds faced a lot of criticism in recent months. Some of these so-called set-it-and-forget-it retirement vehicles lost investors as much as 40% of their savings last year. But that’s little solace for people planning to retire in 2010, many of whom may be forced to delay their plans now that they’ve seen one-quarter or more of their savings vanish. The five-biggest 2010 target-date funds lost an average of 29% from the start of the market’s fall in mid-October 2007 through March 9 of this year.”

As the employer, you can see how convoluted target date fund industry has become in its short life ranging from how portfolios are constructed to how participants view the funds themselves. There is confusion at all levels to include the fund industry itself, plan sponsor and employee alike. Here are 10 questions you should ask yourself.

1. How was your target date fund family chosen? What process if any did you create and then follow in choosing your existing target date fund family?
2. How was this decision-making process communicated to plan participants? Did you communicate with them at all? If so, was the decision-making process described to them?
3. What is the amount of equity allocation at retirement? Whether the allocation is high or low, employees must know how much equity exposure they will have at retirement.
4. Number of asset classes? As a general rule in diversification, more asset classes tend to offer more diversification from risk than fewer asset classes.
5. Income or growth? Is the target fund at retirement trying to generate income for
the near-retiree, or is it continuing to manage long-term growth to mortality?
6. More or less volatility? Is the target date fund at retirement objective to lower risk of account flucuations (volatility) or continue to manage asset growth to mortailty?
7. Does the program seek to maximize the participant’s savings to retirement or to the end of life? Employees need to know which goal their target date fund family is seeking to accomplish.
8. Do you prefer target date strategies seeking to minimize downside risk or seek to maximize upside return potential?
9. Do you believe that diversification can be achieved primarily with traditional asset classes such as stocks, bonds and cash? Or do you believe diversification can only be achieved by extending beyond traditional asset classes?
10. Review your current target date fund offerings. Is the current program offering what you want? Do you know what you want? Do your employees know what they have?

Which Target Date Fund family are you?

targetfundsanalysis1

It may be time to realign your target date fund portfolios. You should create a written process for initial and ongoing monitoring of target date funds. Communicate that process to employees.

We can help.

David Gratke Wealth Advisors, LLC has the tools necessary to engage plan sponsors to monitor and manage their company’s target date fund program. Contact David Gratke to begin the review process. We look forward to discussing this matter with you.

Additional articles on recent Target Date Funds:

No Quick Recovery for Hard-Hit Target Funds, WSJ June 4, 2009
Target-Date Mutual Funds May Miss Their Mark, NYT June 25, 2009
Funds resist regulation of target date pensions Financial Times, July 5, 2009
Failure of a Fail-Safe Strategy Sends Investors Scrambling WSJ, July 10, 2009

Posted in 401(k), Retirement Plans, Simplified 401k, Target Date Funds | No Comments »

Investment Opportunities in a Down Market

Wednesday, June 10th, 2009

What to do? What to own? Where to invest?

How well are you managing risk these days?

Over the years, I have analyzed many a client’s 401k statements. A typical 401k plan allows for many investment options in the name of diversification. Oddly, almost all of these options will lead to a similar result when markets move in any direction. That’s not diversification at all.

Many years ago, I realized that I would need to create asset allocations much differently than what the herd of the marketplace offered. The garden-variety asset allocation of large-company, medium-sized company and small-company stocks was not going to cut it. This doesn’t reduce risk.

What the investor needs is an “inverse” asset class that moves up during sharp, major market declines. This asset class offers superior protection against downside risk when compared to traditional asset allocation models. Traditional asset classes are highly correlated offering little downside protection during major market declines.

Years ago I also realized that creating client portfolios one ‘stock pick’ at a time was a kin to the surgeon awakening the patient from surgery asking for approval to tie another suture. This cobbled-together approach was of no interest to me. Rather, my desire was to create portfolios in a holistic approach thus maximizing the client’s probability for financial success.

This led me to the direction that I have been practicing for years, using the services of professional ‘strategists’ (which is what our industry calls investment firms that create asset allocations).

I have detailed this approach within my practice through a blog posting date July 11, 2008 titled “Dave, How Do You Construct Portfolios?” Therefore I will not spend time on this matter here. What I was looking for years ago, and thankfully found, was a portfolio strategist who exhibited forward thinking in portfolio construction. Simply, it was not good enough to just use past performance for asset allocation design.

A part of the forward thinking is the use of inverse asset classes to manage and mitigate short-term market declines. Although client assets were down in 2008, the use of an asset allocation design to include inverse asset classes reduced the size of decline compared to the broad market. Let me review and focus on the asset allocation tools inside my ‘virtual’ toolbox that have offered superior risk mitigation in 2008 and well in to 2009.

What are these Inverse Asset Classes?

Let us look at the asset class that is at the heart of the inverse asset class strategy as described above. This tool is called AMP for Actively Managed Protection. AMP is a tool managed by a 150-year-old international asset manager, Credit Suisse Asset Management (CSAM). CSAM was hired to manage put options, an asset class that has been available to institutional investors for decades. Put options, which give the holder the right to sell a security at a fixed price, move in the opposite direction of the broad market indices. Put options have received a bad rap over the years, as many individual investors have been attracted to options for mere speculation. However, placed in the hands of professional institutional asset managers, put options serve their intended purpose, which is to mitigate large losses inside of one’s portfolio.

As can be seen from the chart below, when the markets fell in 2008, the cumulative return of AMP rose significantly. This is the design of AMP. A cynical individual might opine, why not just invest in AMP entirely last year? That would be speculating, and that’s what many ‘retail’ investors do with the asset class, and lose.

By the end of 2008, the conversation was no longer theoretical

As you can see in the chart below, the highest value of AMP in 2008 was on November 20th, the market low for 2008. AMP was doing exactly as it was required to do; move up in dramatic fashion while the broad markets plunged. Until this year, the idea of AMP inside a client portfolio was mainly a theoretical discussion as to how it could work in a severe declining market. By the end of 2008, the conversation was no longer theoretical.

amp1

The use of inverse asset classes can be found in a number of strategies available through my firm. Two of the strategies inside my ‘virtual’ toolbox that continue to offer superior risk mitigation in 2008 and well in to 2009 include:

Preservation Strategy (PS)

Risk Mandate: One downside risk objective

Active Return Opportunities (ARO)

Risk Mandate: Includes six downside risk objectives

A quick graphic review of the strategies during fourth quarter 2008 follows:

Below you will see 4QT 2008 (green) and full year (blue) 2008 performance of the Preservation Strategy compared to a 60/40 mix of S&P 500/Barclays Aggregate Bond Index as well as the S&P 500 Index.

During the fourth quarter (green), the Preservation Strategy declined a very modest 0.2% as compared to a 11.9% decline for the blend and a 21.9% decline for the S&P 500 Index.

For the full year (blue), Preservation Strategy posted a negative 4.7% as compared to -22.1% for the 60/40 blend and -37.0% for the S&P 500 Index.

wp1

Below you will see 4QT 2008 performance for three risk profiles for the Active Return Opportunities (ARO) Strategies. For each of the risk profiles, there are three asset allocation strategies, Domestic, Global and Current Income. The grey bars reflect the returns for the S&P 500 Index and the 60/40 index blend.

In all ARO profiles, fourth quarter return was much less negative for all strategies when compared to comparable unmanaged indices.

gfam2

I offer those of you who are not David Gratke Wealth Advisors, LLC clients the following:

A Cup of Coffee and a Second Opinion

When the markets turn as volatile and confusing as they have over the past year, even the most patient investors may come to question the wisdom of the investment plan that they’ve been following.

At David Gratke Wealth Advisors, LLC, we’ve seen a lot of difficult markets come and go over the past twenty-three years. And we can certainly empathize with people who find the current environment troublesome and disturbing. We’d like to help, if we can, and to that end, here’s what we offer, a cup of coffee, and a second opinion.

By appointment, you’re welcome to come in and sit with us for a while. We’ll ask you to outline your financial goals – what your investment portfolio is intended to do for you. Then we’ll review the portfolio for and with you.

If we think your investments continue to be well-suited to your long-term goals – in spite of the current market turmoil – we’ll gladly tell you so, and send you on your way. If, on the other hand, we think some of your investments no longer fit with your goals, we’ll explain why, in plain English. And, if you like, we’ll recommend some alternatives.

Either way, the coffee is on us. Thanks for reading.

David Gratke

Disclosures:

disclose

Posted in 401(k), Bear Markets, Emotions, Forward Thinking, Inverse Asset Classes, Investment Process, Past Performance, Portfolio Strategist, Preservation Strategy, Put Options, Recession, SPX 500 Index, VIX, Volatility, Wealth Preservation | 1 Comment »