Why should I care about the philosophy of my 401k Plan Provider? The short answer is it will impact your money. Quick point, your Plan Provider is the investment bank, bank, or financial services firm that provides the investment platform that is your 401k plan.
So what does that mean? To put it simply, the theory states that an investor can maximize investment returns and minimize risk by choosing a set of different asset classes in a mix determined by the investors stated risk tolerance. Confused?
Don’t worry. Your plan provider has likely provided a computer model for you which prompts any number of answers from you about your personal tolerance for risk. With that information it has generated a pie chart that identifies which asset classes and in what specific proportions you should invest your money.
The single greatest benefit to you is it prompts you to diversify your investments. This is, in my opinion, always a good thing.
The potential pitfall in this philosophy rests in two assumptions. The theory assumes that markets are efficient and investors are rational. One other critical assumption is that the degree to which asset classes are correlated is fixed.
For example: if the historical correlation (called “Beta”) of a mutual fund is 0.50, what that means is that for every $1.00 move up OR down in, say the S&P 500 index, the mutual fund will move, in this case 50%, in the same direction. Now suppose the Beta, for whatever reason, changes say from 0.50 to 1.50: Where you may have expected the mutual fund to only fall at 50% of the rate of the decline of the S&P 500 index it fell at 150%! Say the S&P 500 index fell 20%, the decline in a mutual fund with a Beta of 150% would be a 30% decline which would be a shock if you expected it to only fall 10%!
If recent history is any guide, and we really have nothing else to rely on, not one of these assumptions has held true.
Markets are not always efficient; investors are not always rational; and, historical asset class correlations are not always fixed.
Remove theses assumptions and, in practice (read: in your 401k account), the theory does not work. And, if your plan does an annual, automatic rebalancing of your account to maintain that mix of asset classes… the answer is the same
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