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As I pointed out last week , research shows that most investors and investment advisors woefully underperform the markets. How woeful is woeful? Over the past 30 years, it meant leaving an average of $7,100 per year on the table for every $100,000 invested. For a 401(k) that grows to $1 million at retirement age, this means $71,000 less in retirement income to spend every year. That’s a really big deal.
The reason: when it comes to investing our brains are wired for failure, and that includes the brains of investment advisors.
You need a system that will make it difficult to give in to your brain's tendency to panic and sabotage your investment strategy.
Research shows one system that works is to invest a specific percentage of your portfolio in several asset classes and then readjust (by buying or selling gains or losses) each asset class back to the original target allocation at least once a year. This is called a static buy-and-hold strategy with periodic rebalancing.
Creating such a diversified portfolio is simple enough. The hard part is to keep following the strategy during market ups and downs. The easiest way I know of doing this is to give the maintenance of your asset allocation and rebalancing over to someone else with the disciplines and processes in place to follow the strategy, come hell or high water.
Many 401(k) plans will do this for you if you set them up correctly. First, you will do best not to use the asset allocation fund provided on the 401(k) platform. The recent 21st annual Quantitative Analysis of Investor Behavior by Dalbar found the asset allocation fund’s overall performance is even worse than that of investors and their advisors.
To do this yourself, determine the asset allocation that makes sense for your age, income needs at retirement, and risk tolerance. If you're in your 20’s, this may be an allocation of 90% in equity and alternative investments and 10% in bonds. If you're in your 60’s, this may be 60% in equity and alternative investments and 40% in bonds. If you're retired, with a low risk tolerance, plenty of pension income, and no apparent need to ever tap your portfolio, you might allocate 30% to equities and alternatives and 70% to bonds.
Next, from the available mutual funds in your plan, select the funds in each asset class that index their market or that have the lowest expense ratios. For example, let’s assume you are 55 years old. Your employer’s 401(k) plan has a global equity index fund, a REIT (real estate) Index fund, a commodity index fund, and a total bond market index fund. A possible allocation would be 30% in global equity, 15% in REITS, 15% in commodities, and 40% in the total bond market fund. Set your periodic contributions to go into these same funds at the same percentages.
Finally, pick a firm annual date to rebalance the portfolio yourself. Schedule it as an important appointment and do it without fail, excuse, or hesitation. This step is imperative to long-term success.
Even better, an increasing number of 401(k) plans will do this automatically and allow you to choose a periodic (quarterly or annual) rebalance option. Set your allocation, choose the automatic rebalance option, and you are now on autopilot.
Another solution is to find an investment advisor who employs a static buy-and-hold strategy with periodic rebalancing. Of course, there will be an annual charge (the average is $10,000 or less per million). Compare that with earning an extra $71,000 a year in income over 30 years, however, and it becomes a phenomenally good buy.