ScaredyCatGuide to the 401(k) - Part 9: The Misconception Risk and Asset Allocation

I want to clear up a misconception when it comes to allocating or diversifying risk in your 401(k) account. It should serve you well as you review target date funds and your investment accounts on a whole

A portfolio that is 50% stocks and 50% bonds is not evenly weighted when it comes to risk. At face value this statement may not make sense, but let me explain.

The risk you are exposed to when invested in stocks is higher than when invested in bonds. In fact, stocks are generally considered three times as risky as bonds (because they are more volatile).

Volatility represents how large an asset’s price swings. It can be measured in many ways. For stocks a “beta” is the most common.

There is a mathematical formula to derive a stock’s beta, but for our purposes just know it shows you the volatility of a stock compared to the overall market. A beta of “1” means volatility is in line with the market. A beta above one means the stock is more volatile than the market. A beta below one means the stock is less volatile than the market. Thus, the higher the beta the higher the volatility and the lower the beta the lower the volatility.

Examples of a high beta and low beta stocks are Facebook and H&R Block, respectively.

Given what we just learned about volatility, risk and that stocks are three times riskier than bonds it is clear a 50/50 weighting does not evenly allocate risk.

To truly allocate risk evenly, you would need four times as much in bonds compared to stocks. Being that stocks are three times more risky an allocation of 20/80 stocks to bonds would bring you near risk parity.

In a time of capital preservation such allocation would make more sense. Knowing your time horizon is vital and allocating your investments to suit that is prudent.

UPDATING YOUR ALLOCATIONS

When you allocate between different investment types in your 401(K) account you are practicing diversification. This practice is one of the most common things people are aware of when it comes to investing. “Don’t keep all your eggs in one basket” is the common saying.

The problem people run into is letting one basket become too much of their overall 401(k) account. The problem is you can be well diversified between stocks, bonds and other asset classes while being allocated very poorly. That is why it is better to focus on allocation to lead your diversification.

We just talked about how stocks are more volatile than bonds, and thus can produce better returns. Well, when they produce a better return and become worth more, they now represent an even larger percentage of your account.
This is where your risk can get out of whack. During your early and middle investing years most industry experts advise having a 60/40 stock to bond allocation for your retirement accounts

Allocations fluctuate constantly though. This is why reviewing them once a year is important.

Here’s an example:

• $6000 invested in stocks • $4000 invested in bonds • Total value = $10,000 with 60/40 split

Over the course of a year the stocks grow by 30% (the S&P 500 return for 2019) and bonds earn you 4% (a solid return in today’s low rate environment).

New Values: • $7800 in stocks • $4160 in bonds • Total value = $11,960

What is the allocation now?
• 7,800/11,960 = 65.2% • 4160/11,960 = 34.8%

Your allocation is now 65/35 after just one year of stocks outperforming. Do you see how after a few years of bull market gains your allocation can become grossly distorted and very high in risk?

If you are in your early working years having an allocation run up to 70/30 is okay, in fact some financial experts suggest it. Chasing big returns in your twenties when there is plenty of time to recover if things go wrong is an argument that holds weight. However, regardless of your timeline an allocation above 70/30 is putting your investment account at the mercy of stock market swings.

The irony of the whole thing is an asset becomes over weight due to out performance. So why would we want to have less of an appreciating asset?

As we know all markets have cycles and eventually there are pullbacks and bear markets. Throughout your working years you will see more than one of these occasions. The likelihood that an asset class will outperform forever is unrealistic.

In fact, we see this performance phenomenon within the mutual fund industry itself. Often funds that outperform the market and their peers in prior years fail to do so in the subsequent years.

Several years ago the Wall Street Journal did an article called “Investors Caught with Stars in Their Eyes.” It delved into a study where researchers looked at the performance of 5-star rated mutual funds over the next 10 years.

What they found is that less than 2% of the 5-star funds kept that rating after 10 years. That is pretty wild to think about considering the vast majority of people pick 5-star funds when selecting investments for their 401(k) account.

Most mutual funds have specific segments and sectors they focus on. Being that a given sector will outperform at times and underperform others, it is no wonder managers struggle to hold 5-star ratings. They have an allocation issue based on the range of investments within their scope.

These are the reasons it makes sense to rebalance your allocation even if it means pulling money from an asset class that has been kicking butt. If left unchanged the allocation can become so distorted that when the inevitable market down turn comes, your 401(k) gets wiped out.

Plus, since markets have cycles those assets that may have underperformed in the past may be due for some appreciation just at a time when you are allocating into them as part of the rebalancing efforts.

USING CONTRIBUTIONS TO UPDATE ALLOCATIONS

Rebalancing the allocation percentages in your 401(k) can be done by selling a portion of the investments that are overweight and buying the ones that are underweight.

However, as we saw when reviewing fund fees there could be a charge when making these transactions, thus reducing your overall return. Checking for these fees before making such transactions is wise. If you do make a change, aim to apply the money to a mutual or index fund that has little to no transactions fees.

Another way you may update your allocation, without incurring sales transactions is to adjust the way your contributions are invested. With each paycheck you receive a set amount is taken and goes into your 401(k) account. Let’s say with every paycheck 60% of that contribution goes into stocks and 40% into bonds, but your 401(k) allocation is currently overweight stocks.

You could adjust the way your contributions are invested so that 60% goes into bond related investments and 40% goes into stock related investments.

This would gradually tilt your allocation back into balance without you having to do anything more than make one adjustment to your account. You let the updated contribution ratio work for six months to a year and then check on it and re-adjust as needed.

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