Top 12 Mistakes 401k Investors Make

Top 12 Mistakes 401k Investors Make

Today's 401k accounts are mainly made up of mutual funds. Unfortunately, most investors have no clue as to how much their 401k costs them. Here's how to fix several common 401(k) problems


Here are the top 10 401K mistakes investors often make:

  1. Thinking the 401k is a free account
  2. Not having a written, proven investment strategy
  3. Not having a systematic formula to determine what type of funds to buy and how much of them to purchase
  4. Investing while looking in the rear view mirror.
  5. Overlapping investments
  6. Lack of professional support
  7. Asset allocation Train Wreck for 401k plans
  8. Moving your 401k to a salesperson and not a trusted fee-based advisor
  9. Staying in your 401k when you have the option of moving to an IRA
  10. Thinking someone at your company is watching over your account
  11. Investing in high commission-based investments
  12. Not learning from the history of the market

Mistake #1: Thinking the 401k is a free account

We first need to learn what the fees are. Mutual fund fees come in four flavors:>

  1. Annual expense fees - These can be found in the prospectus. They pay the fund manager, and can vary substantially.
  2. 12b-1 fees - Again, these can be found in the prospectus; they pay for the fund's advertising. Generally, they are between .25% and 1% per year.
  3. Sales loads - Simply speaking, these are the commissions paid to the representative for selling you the investment. The most common structures are A, B and C shares. Different share classes will make sense for different circumstances, but they all add costs to your investment. Again, the prospectus is a helpful tool to determine these fees. (Most larger 401k plans do not have sales loads attached to their mutual funds.)
  4. Portfolio turnover - This one is the wild card. Portfolio turnover refers to how much trading is done within the fund throughout the year. The higher the percentage, the higher the costs. Mr. John Bogle's research tells us that conservatively speaking, you pay .5% additional fees per 100% turnover. This may vary from year to year if the fund trades more in some years and less in others.

When you start adding up all the fees, it is not unusual for a fund to cost you more than 2.5% per year. If the markets average 10% per year, then you could easily see 25% or more of your gains eaten away by fund expenses.


Do these expenses show up on your statement? NO! They are taken out of the daily price per share of the mutual fund. As wise investors, we need to know exactly what we are paying, and we must do our best to keep our costs low. I'll let you figure out how the math works when the market is going down...(Hint: do you think the expenses go away in a down market?)


Mistake #2: Not having a written, proven investment strategy

Successful investors follow a proven strategy and system. Experienced investment advisors call this an "investor policy statement" where you put your goals, dreams, and limitations down in writing. The money is managed according to your long-term objectives and assumptions, not on hot tips or 'winging it.' This keeps both sides accountable and removes emotion from the decision-making process.


After dealing with thousands of 401k investors, one thing was shockingly clear to me. Most investors are "winging it" with the largest portions of their retirement! Amazed? Read on. One of the questions I would ask most participants was 'How does this 401k account fit into your overall financial strategy'? Are you ready for this? MOST people didn't have an answer. If you are in this camp, please think long and hard about your long-term goals and objectives. The burden of responsibility for employee's retirement has been transferred from employers to employees. This means we all have to make the best possible decisions with our hard-earned savings.


Mistake #3: Not having a systematic formula to determine what type of funds to buy and how much of them to purchase

Many 401k companies today only offer between 5-30 choices for your 401k, yet it can take as many as 6-10 asset classes and 12-15 investments to property diversify your portfolio. Many 401k plans don't even offer all of the asset classes we use with our clients as options within their plans.


So out of the 10,000 investment options available, you are working with 5-30 choices. I have found most 401k investors choose the funds in their plan based on past performance, tips from fellow employees, and sales material the record keeper of the 401k sends out. Unfortunately, this ends up in an asset allocation disaster.


During my tenure at Fidelity it was easy to spot clients with financial planners because it was obvious when looking at their investments. Less than 5% of the 4500 accounts I saw had what I would consider a good mixture of investments. The company that handles your 401k is getting paid based on the fees they charge your employer AND the annual expenses you pay. Basically, they are making lots of money whether you succeed or fail. If you are still an active employee, don't expect much help from the firm that handles your firm 401k. They will probably not even contact you until you retire or change jobs, BECAUSE IT IS AT THAT POINT YOU CAN FIRE THEM!


Mistake #4: Investing while looking in the rear view mirror (Investing in HOT FUNDS that have been making lots of money)

If you learn nothing else from this report, PLEASE do not invest your portfolio in the "hot funds." Although hot funds are those which have done well in the most recent time frames (think Technology in 1999/2000), this is by far the easiest way to lose money in the market. Dalbar reports that from 1982 to 2002, a period when the market averaged over 12.75%, the average investor only earned 3.5%. That is like paying an 8% load EVERY SINGLE YEAR! Why? Because investors buy high high, sell low, chase returns, and invest in expensive products with high annual expenses.


Investors lose money by extrapolating some previous trend too far into the future. Here are a few painful lessons some investors have learned the hard way:


1980: Commodity, Precious Metal and Oil Craze

1990: Japan Craze

1998-1999: Index Fund Craze

1999: Large Cap Craze

1999-2000: Technology, IPO, and garbage.com Craze

Today: Real Estate Craze along the East and West Coast


Want a good investment idea? AVOID every super-popular investment you find. This will keep your portfolio intact for the long term. Develop a strategy and stick with it.


Mistake #5: Overlapping investments

Ever wonder why you own 5 mutual funds, but your account either stays flat or goes down? One reason could be your investments are too correlated to one another. This means you can own 4-5 mutual funds, but the funds could be investing in the very same stocks. One great example is Fidelity Magellan and the S&P 500 index fund. Did you know that over the past few years they were 98% the same ' only Magellan was three times as expensive' If you held both funds, you received basically NO diversification. The point behind asset allocation is that by spreading the money in your portfolio around (we call it reducing standard deviation or variability of returns), some areas do well when others don't.


We have special software and tools which allow us to gauge the overlap of investments inside your account. Therefore we can make sure you are not doubling up on exposure to certain areas of the market. Often we will hear people complain about losing money with their investments. Unfortunately, these people treat investing like a game, and do not take advantage of the time-tested techniques of preserving and protecting their wealth.


Mistake #6: Lack of professional support

Have you had a professional financial planer review your 401k in the past 2-3 years? 85% of the people I surveyed said NO! Yet in many instances 401k money represents the largest piece of retirement savings people have today. It is NOT uncommon to see 80%-95% of available assets invested in 401k plans. Here investors are winging it on their own with a large portion of their assets. Many 'financial advisor' types only want to help you if you are retired or terminated because they can't make money unless you transfer your portfolio to them!


I would encourage you to work with a CERTIFIED FINANCIAL PLANNER' who can help review your investments and provide advice ' regardless if you are retired or still active with your employer.


At my firm we have 2 options for our clients. One is a retirement check up where you pay a flat fee for a portfolio review. The other is letting us manage your account for a fee or percentage of assets per year. The choice is yours. By the way, steer clear of 'advisors' who act like salespeople and pitch loaded funds, B shares, or annuities. In many instances they are doing so either because they want to maximize their commissions or they can't charge you annual fees to manage your accounts. Know exactly what you are getting yourself into!


Mistake #7: Asset allocation Train Wreck for 401k plans

Have you ever wondered how really smart people invest their millions and billions of dollars? Harvard and Yale have both produced some of the smartest investment minds in the industry. Today their alumni often run mutual funds, hedge funds, and private endowments. They sit on institutional boards and run some of the largest investment firms in the US. Basically, they are the 'Who's Who' of the investment world.


You might not know this, but Harvard and Yale are very well known in the investment world for having the most successful endowments today. They have flat out been CRUSHING their peers. This chapter is meant to illustrate how they invest their private endowments (otherwise known as their private stash of cash) and compare that to how many individual investors handle their 401k accounts.


Harvard's Asset Allocation:

15% US Stocks

10% Foreign Stocks

5% Emerging Markets

13% Private Equity*

12% Absolute Return*

5% High Yield

13 % Commodities

10% Real Estate

11% Domestic Bonds

5% Foreign Bonds

6% Inflation Protected Bonds

-5% Cash (to spend)

*Might not be available to individual investors


Notice the difference here' Harvard calls their investments 'a well-diversified portfolio with an attractive risk-return ratio.' What do you think they would call most 401k accounts today' I bet they say they're a train wreck waiting to happen. Notice how Harvard spreads their billions around nine different asset classes. Their endowment feels this mixture helps to increase their return while reducing risk!


Not a fan of Harvard? Here is what Mr. Jim Swenson, the manager and person who runs Yale's endowment said:


'Currently at Yale, we've got a half dozen asset classes that individuals ought to have in their portfolios. Traditional bonds, inflation-indexed bonds, US Stocks, foreign developed stocks, emerging market equities, and real estate securities.' He then argues we should limit ourselves to 30% in US stocks.


He went on: ?The problem with the mutual fund industry is that you've got a sophisticated provider of investment services on one hand, and, on the other, you have an unsophisticated consumer. That imbalance leads to behavior that lines the pockets of mutual-fund managers at the expense of the individual investor.


How does your portfolio compare to what these two fine educational institutions are doing with their own money?


By the way, if you have a professional advisor, he/she could be abusing you as well. Most advisors are trained as salespeople and not as planners or investment experts. I would be willing to bet we are the FIRST people to show you the Harvard and Yale philosophies. Yet many trust departments at banks implement these types of strategies with their client accounts. It's not fair that only people with $25 million dollar accounts at bank trust departments get to implement these strategies!


Mistake #8: Moving your 401k to a salesperson and not a trusted fee-based advisor

Let's assume you wanted to delegate your portfolio to a trusted financial advisor. What should you look for? Here is what I would consider, based on my seven years in the industry:


Someone who has already been in the industry between 5-10 years and will continue to be in the industry for a while.


Someone who has designations after their name. CFP? preferred


Someone who works on a fee-basis rather than as a salesperson (no loaded funds, expensive annuities or B shares.)


Someone who takes time to review your big picture.


Someone you trust.


Someone who has an open architecture (no 'product lists.') Many banks and insurance firms have small product lists for their advisors to choose from. JUST SAY NO! (Advisors call this their approved list.)


Someone who does not sell proprietary products.


Someone who is going to work with you in the future (quarterly and semi-annual reviews.)


Someone with an educational background in business & investing (finance degree, MBA or both.)


Someone who is associated with a boutique/specialty firm (I consider independent advisory firms my stiffest competition.) Happy clients rarely leave them.


Someone who takes a planning-based not a product-based approach.


Someone who will prepare a comprehensive financial plan rather than just focusing on investments.



Mistake #9: Staying in your 401k when you have the option of moving to an IRA

In the next section of this report, we'll go into great detail as to why individuals should consider moving their 401k/Pension account to IRA accounts instead of leaving them in their employer-based plan. To summarize, here are a few of the reasons:

  • Professional help
  • Greater withdrawal options
  • Much wider range of investment options
  • Access to asset classes/institutional shares not offered in 401k plans
  • Beneficiary options after death
  • Special tax treatments of highly appreciated company stock
  • Access to after-tax money to use for spending
  • Breakaway from restrictions the company placed on withdrawals or exchanges
  • Elimination of some of the fees 401k plans can charge
  • Avoidance of 401K plan destruction to your estate planning (401k plans often kill bypass trusts a/k/a AB trusts)

Mistake #10: Thinking someone at your company is 'watching over your account'

401k accounts are self-directed. What that means is that YOU are ultimately responsible for making EVERY decision regarding the welfare, maintenance, and performance of the account. Some retirees who have worked for their employer 25+ years often have the misunderstanding the company has 'done what is right by them.' This varies based on the company. The important thing to understand is that your 401k is like an account you would hold at a discount broker. EVERY decision is up to you. In today's competitive global marketplace, companies are more concerned about making money than the welfare of your retirement account. You need to act accordingly.


Mistake #11: Investing in high commission-based investments


There is a huge difference between an investment advisor and a 'broker.' Investment advisors are fiduciaries who are legally responsible to act in your best interest. 'Brokers' might make more in commissions in 5 minutes on your account than a trusted advisor might make in 6-7 YEARS. Therefore the sales pitch is going to sound nice and juicy.


Unfortunately, many large banks, investment firms, and 'brokers' want only one thing.


Their goal is to generate the highest revenue with the least amount of effort and money possible. This might not even be the broker's fault. Six years ago I worked as a 'registered rep' for a regional bank in Dallas. Many of the 'brokers' for the bank sold the highest commission-based products because the bank had structured our pay plan in such a way that they sometimes kept 80% of the revenue.


Here are the some of the highest commission products 'brokers' might try to pitch you:

  • Equity Indexed Annuities ' Commissions up to 10-12% of the amount invested (you invest $250,000 and that firm gets a $25,000 payday!)
  • Loaded Mutual funds ' Usually 5% up front of backend fees. Loaded funds are not all bad, but the advice you get AFTER THE PURCHASE is going to vary a lot. What incentive does a 'broker' have to work with you if they already have made their money? If you do purchase loaded funds, make sure your broker is using breakpoints to lower your overall fees.
  • High Expense Mutual funds ? There are funds out that that have annual expenses over 2%. Add in trading costs and you might be doomed before you even begin (2.5% on $250,000 is $6,250 PER YEAR.)
  • Expensive Fee-based Advice ? Add up ALL of the fees. You might have to pay your broker, your broker's firm, investment managers, and trading costs. The higher the total number, the harder it will be for your portfolio to survive.
  • Variable Annuities Loaded with Guarantees ? Insurance companies have gotten very creative. You can now buy all type of guarantees with annuities. However, the devil is always in the details. Read the fine print! These annuities pay 6-9% upfront commissions, so keep that in mind. Be skeptical.

Here is what a former SEC Chairman has to say on the issue: ?You should fire your broker and find an investment advisor. Brokerage firms would like you to think that they perform the same functions as investment advisors. Many brokers call themselves "financial consultants" or "financial advisors". But they are not the same as independent investment advisors... an investment advisor's fiduciary duty is on a higher plane, like that of a lawyer, a trustee, or the executor of an estate." - Arthur Levitt, Former SEC Chairman


Mistake #12: Not learning from the history of the market.

Market Cycle # Total PE RATIO INFLATION DOW JONES
From To Years Market BEG END BEG END BEG END
1901 1920 20 BEAR 23 5 -2% 16% 71 72
1921 1928 8 BULL 5 22 -11% -2% 72 300
1929 1932 4 BEAR 28 8 0 -10% 300 60
1933 1936 4 BULL 11 19 -5% 1% 60 180
1937 1941 5 BEAR 19 12 4% 5% 180 111
1942 1965 24 BULL 9 23 11% 2% 111 969
1966 1981 16 BEAR 21 9 3% 10% 969 875
1982 2000 18 BULL 7 42 6% 2% 875 11497
2000 - - BEAR 42 - 3% -/td> 11497 -
Source: Crestmont Research

One of my personal passions is studying the history of the stock market and the economy in general. My fascination began in 2000 watching the NASDAQ crater. I became intrigued with the market fallout, especially how Wall Street could have been so wrong.


If you remember, Wall Street was pumping up the biggest stock market bubble of all time & reinforcing our beliefs that the stock market 'always goes up' and that we were in a 'new economy.'


The chart above is one of the very best educational pieces I have ever seen.


What I want you to learn from this chart is the following:

  1. The stock market has a history of going from Cheap to Expensive and back again over long periods of time.
  2. The larger the bull market, the longer the bear market that follows it.
  3. Inflation historically rises from low points to higher points during bear market periods.
  4. The stock market historically does well during periods of falling interest rates and falling inflation.

What does this mean for the future?

  1. Investors need to prepare themselves for the fact the US stock market (as a whole) might stay flat or 'muddle through' for several years to come.
  2. Inflation during this period historically rises.
  3. You want to invest some of your portfolio in assets that do well during times of rising interest rates, higher levels of inflation, and a flat stock market.

To sum up, the flat market we have experienced since 2000 is perfectly normal and might continue for some time to come. This is one reason I love the Harvard Endowment approach for the upcoming 5-10 years. This approach should help diversify your portfolio, thus hopefully giving you a higher return with less risk.


Most 401k plans are not set up to do well during secular bear periods because most 401k plans lack the investments that do well during secular bear periods.


Hint: Historically, commodities are the place to be when the market goes sideways. Rising commodity prices are usually bad for corporate earnings.

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