Why is Your 401k Fund so Risky? Because Experts are Telling You to Buy Funds Run by Clerks Managing Other People’s Money (with no skin in the game)!
In last week’s story, Joe was forced to retire a decade later than planned because his portfolio took a tumble. And it took 12 years to recover.
Why did Joe take so much risk?
Because he took the advice of an “expert.” Joe was a fan of Dave Ramsey. Dave Ramsey helped Joe get rid of his mortgage and start aggressively saving in his company 401k. That was great advice.
Dave Ramsey also told Joe he could make 12% per year by investing in “good growth stock mutual funds.” Joe following this advice, and picked a mix of funds that had high ratings.
But he didn’t have any idea how his funds were managed and how the ratings were assigned.
Dave Ramsey doesn’t talk about this because it’s complicated to explain. In general, he advises his followers to invest in funds that have “consistently performed well.”
After good market runs, this includes all of the largest equity fund families like American Funds, Dodge and Cox and Vanguard.
Dave Ramsey doesn’t explain why funds are risky (probably because he doesn’t understand it). He’s also paid not to understand it. He refers his followers to a network of Endorsed Local Advisors who sell funds offered by the largest equity families. But I am not here to bash Mr. Ramsey, who does a lot of good for a lot of people helping them get rid of debt (we like that!). I am here to clarify why this is bad investment advice.
The overwhelming majority of “good growth stock mutual funds” offered in employee 401k plans are so risky is that the fund “managers” buy more stocks when they get more expensive and sell them when they get cheaper. This is because they are benchmarked to “market capitalization” weighted indexes. They have to –it’s standard practice. The publicly traded companies they work for make them do that in order to get high ratings. There is less “career risk” benchmarking and the “managers” are less likely to get fired.
I can imagine how you may be confused by the term “market capitalization weighed”, so rather than define it let’s use a Dave Ramsey concept to explain it. We love Dave Ramsey on budgets.
Most folks live on a budget. Which means they can only spend a set dollar amount, for instance on food. Now imagine you only ate rice and beans. Let’s assume rice and beans both cost the same amount, say $1 a pound. If you budget $100, you would spend $50 on rice and $50 on beans and you would have 100 pounds of food.
Suppose the price of beans rises 50% to $1.50 and the price of rice falls to $.75. In order to buy the same amount of beans you would have to spend $75 ($1.5 x 50). Which means you would only have $25 left to buy rice. Because the price of rice fell to $.75 you can buy 33 pounds. But you are still left with only 83 total pounds of food. Which means someone is going hungry (that’s 17 lbs. less of food!).
Now suppose you don’t care whether you eat rice or beans, you just want to have 100 pounds of food. In this case you could buy 100 pounds of rice for $75 and have $25 left over. But if you like diversity and want to spend the entire $100, you could some beans and rice in any mix that totals $100 ( for instance 32 pounds of beans and 68 pounds of rice and still have $1.00 left over).
But the point is that you would never, ever, buy more beans when the price rises. And this is exactly what fund managers do if they are worried about their “rating”. These fund managers buy more stocks that have become more expensive (think beans) because the price went up. And they sell stocks when the price goes down (think rice).
The reason nearly all portfolio managers do this is that they are worried about their ratings. And their rating depends on how well they perform compared to a benchmark (like the broad US stock market S&P 500). So, for instance, when technology becomes 1/3 of the index, the funds need to have 1/3 invested in technology to keep up (so they have to buy more beans).
That’s the problem. Most funds aren’t run by a portfolio manager managing his own money. Instead the person managing the fund has to keep rating high so that he can keep his boss happy. He isn’t managing money like he would his own. We would argue these fund managers are portfolio managers at all. They are clerks taking orders. The clerks taking orders from bureaucrats more worried about keeping beans and rice in balance than they are about minimizing risk or maximizing return. This problem is so widespread that there are even pension consultants advising “risk managers” to look at funds and evaluate them based on how closely they compare to the index.
Which means these fund managers (clerks) have to buy more beans when they are expensive instead of buying the cheap (or relatively cheap) rice.
Which means someone is going hungry. Or has to retire later. Or has to live on less money.
It’s more complicated than rice and beans but you get the gist.
When technology was 1/3 of the US market in 2000, 1/3 of Joe’s investments were in technology stocks.
In 2007 finance was ¼ of the market (so were Joe’s funds). When shares of the bank stocks dropped nearly to zero (some did and most should have), Joe last half of his savings and couldn’t’ retire until 2012.
The more you learn about how these clerks, taking orders from bureaucrats, working for publicly traded companies manage Other People’s Money differently than they would their own, the more you realize you should be invested alongside a real portfolio manager investing his money like he would your money.
Because he wants to avoid losing money that he can’t make back.
Because he doesn’t ever want to go hungry or for you to go hungry. Because he manages your money like he manages his own money. Because he has skin in the game!
Investors managing their own money, not overseen by bureaucrats and often working for PRIVATE companies (that can put their clients’ interests first instead of the company shareholders’ interests first) actually avoided investing in technology in 2000 and in finance in 2007. They didn’t buy expensive beans!
This is an excellent insight to keep in mind. We believe funds will always be managed this way. Which means there will always be an opportunity to buy cheap beans.
Investors are STARVING for good financial advice and portfolio management structured to avoid losing money you can’t make back. Investors have been taking such bad advice from experts that they made only about 3.2% per year in the world’s largest equity fund (as of mid year this year) for the last fifteen years.
They deserve better.
We manage money like we manage our own. We have SKIN IN THE GAME.
We aren’t for everyone. But if you are ready to graduate from a big bank or insurance company to a fee-only fiduciary we should have a conversation.