Think you Can Hit the Right Combination of 401k Investment Choices without Professional Help?

Established 18XX

You have accumulated your wealth by virtue of talents other than managing an investment portfolio. You have worked hard in your field and have had the presence of mind to put aside money for retirement. Do you have the time and the desire to teach yourself an entirely new professional set of skills? Do you know the right combination of 41k investment choices that will see you to and through your retirement years?

Consider how a professional approaches the market. One the most valuable investment lessons to learn is to simply avoid catastrophic losses. If your 401k investment choices are correlated to the S&P 500 index (and most are) then you have likely experienced the last two market crashes in 2001~2003 and 2008~2009. There is a maxim among investment professionals which is: it is OK to be wrong; but, it is not OK to stay wrong.

While many may look at their 401k accounts and are feeling good that their account balances are at least close to where they were before the last crash, they are overlooking one important fact. Both they and their employer have added new money to the account. Subtract out that new money and the numbers are significantly different.

So how do professionals approach the market? I have seen many descriptions and heard many investment strategies. The common theme is a rules based philosophy. There is an emotional detachment from what is in the portfolio at any given time.

Generally, investment professionals will begin with what is referred to as a “top down” analysis. How they go about it varies considerably. The basic idea is to see if today is a market worthy of my investment capital. Is demand in control of the market? The answer to this question alone would have at least provided the opportunity to have protected portfolios from the two catastrophic losses we recently experienced.

Without this knowledge and satisfied with a “buy and hold” investment mentality, catastrophic losses are unavoidable. At best, hope becomes an investment strategy; and, at worst, denial becomes the default response. I cannot tell you how many people I have met who refused to even open their 401k statements from the middle of 2008 to the middle of 2009. They were in shock. They could not stomach looking at the losses.

Assuming we are in a market that is supporting higher prices ~ demand is in control ~ the professional then continues with the top down approach and determines if the relative strength is in a market capitalization weighted index or an equal weighted index. To clarify, a market capitalization weighted index has to do to with how the index is calculated.

For example, the S&P 500 index consists of 500 stocks; however, a $1.00 price movement of any stock in the index will not move the index price by $1.00. The price change of the index is proportional to the stock’s overall market value, relative to the rest of the stocks in the index ~ hence the term market capitalization weighting.

Let’s take this a step further, the largest market value companies in the index will have the greatest impact on the movement of the index either up or down. Consider that the Dow Jones Industrial Average is only a “portfolio” of 30 stocks. This is hardly “the” market. Many individual investors believe a better measure of “the” market is the S&P 500 index, if only because it is made up of 500 stocks; yet, 40 of the largest companies in the index (only 8% of the 500 names) drive about half of the movement of the index!

The significance of this explanation is that the effect of market capitalization is so dramatic that any one of the 10 largest stocks can have more impact than the entire bottom 100 stocks put together. So, if you believe that indexing is the way to invest in common stocks be aware that there are times when the largest market value stocks do well and times when the smaller market value stocks outperform. The investor who is using the S&P 500 index as “the” market is betting on large cap stocks ~ perhaps without knowing it.

The alternative is an equal weighted index. An equal weighted index is just that. Regardless how large or small the company is each stock carries the same weight. Therefore, even General Electric Company will have the same weight (0.2%) as the smallest company included in the S&P 500. Some Equal Weight Market ETF examples:

EWRI     Russell 1000 Equal Weight ETF

EWRM Russell Midcap Equal Weight ETF

RSP        Rydex S&P 500 Equal Weight ETF

From here the professional considers portfolio construction to include large, mid or small cap stocks; value, blend or growth stocks; and, perhaps industry concentration. Add to that, inclusion of commodities, international equities with concentration in developed or emerging markets, foreign currency investments, fixed income investments to include corporate bonds, international bonds, U.S. Treasuries, Agency Bonds, Municipal Bond, High Yield Bonds, etc., etc., etc..

So if you are still wondering what the right combination of 401k investment choices is, what I would submit to you is that the professional knows that the “right” combination is dynamic. It changes. It is not like the tumbler on a safe that will always open the vault. And, the professional knows that every day is not a good day to buy stock

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