3 (Bad) Reasons 401k Investors are Over-Cautious

April 09
00:48 2013

In 2006, Congress passed the Pension Protection Act. Among the objectives of that legislation was to address several major problems then occurring within 401k plans. One of those snags dealt with retirement investors’ tendency to be too cautious with Rattlesnake signtheir long term investments. We call this Common Mistake of Retirement Investors “Over-Cautiousness.” It means sacrificing long-term return for short-term “safety.” You’ll see why we put that last word in quotes a few paragraphs from now. First, a few facts you be interested in knowing.

According to the “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011,” (ICI Research Perspective, December 2012, Vol. 18, No. 9), in 2002, prior to the 2006 Pension Protection Act, only 40% of 401k plan assets were placed in equity funds. In 2007, this number rose to 48% (still not as high as the market peak in 1999 when 53% of 401k assets were held in equity funds). Following the market debacle in 2008/09, 401k equity fund holdings dropped to a low of 37%. As of 2011, and despite the market recovery, only 39% of 401k assets are invested in equity funds. This means a large segment of 401k investors have missed out on these returns, making it harder for them to meet their retirement objective.

Why is this so? What can be done to prevent this?

Bad Reason #1: “My Feelings are Hurt.”

David Rae, Vice President of Client Services with Trilogy Financial in Los Angeles California, says, “Investors often make investment decision based on emotions ranging from euphoria to fear. In this past recession so many people moved all their 401k holdings to cash, generally out of fear. If you are sitting in an interest bearing account and earning less than the inflation rate you are losing money with no chance of coming out ahead. They’ve also missed the big market recovery many have enjoyed the past few years. On the way up, they often buy, buy, buy with euphoria, which often leads to panic selling when things go south. So many people are stuck in a buy high, sell low pattern. I talk to so many people who have no idea that the stock market has gone up the past few years.”

What are the “killer emotions” exhibited by retirement investors that lead to this behavior? “The biggest killer is watching the financial media and having a crisis to crisis investment prospective,” says Craig Morningstar, COO at Dynamic Wealth Advisors in Phoenix, Arizona. He believes “investing is a life-long experience, from the day we save our first dollar, until we pass-away…..or run out of money.”

Bad Reason #2: “Fool me once…”

Over-cautious retirement investors exhibit very specific symptoms which investment professionals and plan fiduciaries can often spot right away. For example, Morningstar says one symptom is “following the short-term industry performance rating.” This, he says, is caused by investors “chasing returns and looking at data less than 5 years.”

Ozeme J. Bonnette, Financial Coach at Tri-Quest Investment Advisors, based in Fresno, CA, agrees, pointing out, “Many investors were overly aggressive to begin with. They were chasing returns or hot sectors in an effort to ride the up, but were not prepared for the large downside that is possible with an aggressive portfolio.”

Though burned by their own misplaced enthusiasm, retirement investors don’t look at themselves as the problem. Instead, they blame the market, make that, the “tricky” market, or “those evil Wall Streeters” or whatever the class warfare term de jour happens to be. They thus become cautious, leery of having been taken in by a market that “fooled them once.”

Bad Reason #3: “Safety First.”

Investors look at the short-term, especially after market collapses like 2008/09, because they revert to a “safety first” mentality. “For many retirement plan investors, this is their life savings, no matter how large the account,” says Bonnette. “They do not have other savings accounts, emergency funds, or other investments to fall back on. Many of these investors are over cautious because they cannot afford to lose anything. The first sign of a drop in the market causes them to go into protection mode to try to salvage what is left.”

Unfortunately, a simple sense of math explains why this approach is actually dangerous when it comes to retirement investing. Bonnette says, “Being overcautious to the point of moving to cash in a down cycle leads to a very high probability of not recouping losses. Most investors move to cash when the market drops, hoping to get back in when the market is on its way back up. Unfortunately, no one has truly succeeded in timing the market. By the time investors realize the market is rising, it’s too late to catch the huge wave.”

Why is it so hard for retirement investors to understand why “Safety First” hurts them in the case of long-term investing? “Safety keeps investors safe in the short-term,” says Morningstar. “Most investors do not have a long-term perspective,” he continues. “The only way to have a confident long-term perspective is to be investing for years….since a person was a child. Without that experience, the investor needs to understand and believe the numbers. Safety has a cost, most retirement plan investors don’t realize.”

“So, What’s the Cure?”

“One cure for over-cautiousness,” says Bonnette, “is working with an advisor that you trust to help you determine whether the investment’s performance is just a reflection of the state of the market or if there are actual quality issues that require one to sell and reinvest elsewhere. Many retirement investors have such a hard time understanding this because many are not financially savvy. Some don’t have access to information. Others don’t take the time to utilize the resources that are available. I have seen a noticeable difference in the performance of the accounts of clients that I work with when I compare those I meet with regularly to those who choose to work on their own.”

Rae says, “Individual investors are better off working with advisors for a few reasons. Most importantly they can help the investor determine how much they need to be putting away to accumulate enough assets to retire. If the investor has a crystal ball and picks the best investment available in their plan, but don’t save enough they still won’t be able to retire. An advisor is also there to help you avoid the slew of other mistakes that investors make that greatly decrease their odds of becoming financially independent.”

For those unwilling or unable to work with an individual adviser, Morningstar believes the best way to cure the problem of over-cautiousness comes down to this simple rule: “Don’t look at the short-term media.”

It’s important for 401k plan sponsors – and anyone else acting in a fiduciary role – to understand why retirement investors become over-cautious. In this way, they can better construct 401k investment education seminars to deprogram this common mistake from the minds of employees.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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