Friday, January 18, 2008

Time to be conservative with your 401K

Most of the posts I and other financial bloggers write are typically focused on individual stocks or ETFs and managing active portfolios.

For those folks who are more conservative investors, those whose main investment vehicle is a 401K, for example, the techniques for portfolio management might be a little different.

The news of stock markets falling and pundits predicting recession is disconcerting to professional investors as well as to those of us who are watching our balances in an IRA or 401K sag.

What approach should the average 401K investor take?

Let's assume that the investor is contributing on a regular basis to one of these retirement accounts. There are two questions that the investor needs to ask:

1. Should I stop putting the regular contribution into stocks?

My feeling is that investors making regular contributions are being handed a present by the markets. Every week the market goes down, these investors are lowering their average cost. When markets recover, as they eventually will, the equities bought as the market was going down will suddenly look like bargains.

My advice, then, is to keep on contributing regularly and be sure that a good percentage of those contributions are going into stocks, not stable value funds.

2. Should I sell a large portion of the stocks or mutual funds already in the portfolio?

Those 401K investors who have access to a stable value fund should take advantage of it now. A stable value fund guarantees principal and pays a modest interest rate. In these times of falling interest rates on treasury bonds, getting the risk-free 4% or so that stable value funds pay is not a bad deal.

If a bear market is underway, it is a good idea to lighten up on stocks. So I would suggest putting up to 50% of the portfolio into a stable value fund but certainly no more than 50%. This percentage allows an investor to preserve capital and sidestep some of the gyrations we are seeing in the markets these days. But an investor needs to leave a reasonable amount of stock in the portfolio in order to take advantage of the rally that will eventually signal the end of what today looks suspiciously like a bear market. Many studies contend that powerful rallies after major downtrends account for a large part of portfolio gains. For this reason, the investor needs to keep a sizable portion of stocks in the game.

In terms of deciding what to sell, the investor may want to trim each individual position rather than totally liquidate some and keep the rest intact. This decision depends on whether the investor is happy with the current allocation or whether there are some clear under-performers that could be removed entirely from the portfolio.

When the up trend seems to be confirmed and market stability returns, an investor can begin to deploy some of the cash in the stable value fund back into stocks and mutual funds.

This may sound like market timing but it is simply a method to react to major turning points in markets. It is a strategy that can be done incrementally. Worried about the market? Park a little in the stable value fund. Still worried about the market? Park a little bit more in the stable value fund. Market going up and you are worried you are missing the rally? Move a little out of the stable value fund. And so on.

The goals of this strategy are twofold:

First, to smooth out some of the volatility you may derive from staying in stocks day in, day out. You will miss some of the upside of the initial bull market rally but you will have hopefully missed some of the losses of the bear market downdraft.

A second goal is to preserve capital in uncertain times. When markets do rebound, the portfolio won't have to make up so much lost ground just to get back to break-even.

And keep in mind, a stable value fund isn't dead money. Though a conservative investment, it generates interest and ensures that there will be at least some gains, more than likely enough to at least keep ahead of inflation.

So be careful and take the steps needed to ensure a healthy and prosperous retirement.

UPDATE: I received a comment that was vehemently in disagreement with my general thesis in this post about using a stable value fund for capital preservation. My response is that the funds seem to be quite conservative and shouldn't be too exposed to the current turmoil in credit and securitized mortgage markets. David Merkel, who writes for Real Money, has some thoughts on the subject ("Unstable Value Funds?") that seem to confirm my opinion. He also provides further detail on how the funds work in the event they do encounter trouble: ie, returns reduced, principal preserved.

In any case, thanks to Anonymous for the comment which got me thinking and doing further research.

For more on this topic, read Part Two.



7 comments:

Anonymous said...

Are you KIDDING me? On the day that one of the major insurers of bonds held by Stable Value funds is basically put out of business, you RECOMMEND Stable Value funds for asset protection?

You are obviously clueless.

TradeRadarOperator said...

This is something I did consider when writing this post. In looking at the Morningstar writeup on the stable value fund offered by the company I worked for, I felt it was still reasonable to recommend this strategy. It confirmed my feeling that the fund is quite conservative and is not shooting for excessively above-market returns. Other than cash and potentially a government bond fund, there aren't many choices for capital preservation in 401Ks. If the stock market turns up, we know that over-bought Treasuries will surely drop in value.

Anonymous said...

Here is the problem. You are giving general advice based on your specific Stable Value Fund in your particular 401K. Many 401K Stable Value funds are weighted toward mortgage bonds, especially those managed by Dwight Asset Management.

I read that across all Stable Value funds the mortgage exposure is about one third of the assets. That is a huge, huge problem, especially given that there are many SV funds that have no exposure at all to mortgage bonds. This means some have the majority of their money in mortgages.

With the demise of the monolines, some SV funds are going to have serious book to market gaps, and given the Billions in 401K funds in unstable SV funds, there could be a huge disaster.

BTW, how do you know what your SV fund holds as investments? Most refuse to reveal this information.

TradeRadarOperator said...

As I have looked into the background on SV funds, I can see your point. The fund I am most familiar with seems somewhat middle of the road. They don't disclose their specific investments but they do list sector allocation, top issuers, portfolio diversification and quality and duration distribution. Based on this information, I am reasonably confident that my principal is safe.

As for the bond insurers, most SV funds use diversification to reduce risk. It is not unusual for a reasonably conservative SV fund to use 15 different insurers. Many insurers are part of large, well-capitalized companies like AIG. Ambac, MBIA and ACA are, so far, in the minority (let's hope it stays that way).

Bottom line, I agree that holders of 401Ks should do as much research as possible on their stable value funds to determine what kind of exposure to mortgage-backed assets exists and how dependent the fund is on "juicing" returns via riskier credit vehicles. It appears to be true that not all stable value funds are created equal.

Once again, thanks for your comments, Anonymous!

Anonymous said...

As a former Trader on a retail trading desk, I can tell you that the strategy you are talking about does not work well for most people. You are talking about a sell low and buy high strategy. This is market timing and should only be done by those who understand it. Most people should be doing the opposite of what you suggest and start moving into balanced funds or bond funds when the market has been outperforming its average return over a period of time. The S&P 500 has already fallen over 15% from its high. Don't you think it would be better to have started telling people to lighten their loads when the S&P was hitting 1500 instead of now when its going down to 1300?

TradeRadarOperator said...

As you point out, timing is everything. I would like to make two points here.

One, if we are on the brink of a bear market, we could see markets drop another 15% or so. Bespoke recently wrote that the average bear market shows a loss of well over 30% from peak to trough. It would we worthwhile to shield a portion of a portfolio from the remaining drop if we are headed for a bear market.

Secondly, over the last couple of months I have lightening up on some of the sectors that have been falling quicker than the rest of the market, small cap value, for example. Initially I moved the funds into large cap growth and international bonds. More recently, as news grew more alarming and markets have fallen quicker, I have lightened up some of my larger positions by moving the proceeds into my stable value fund. After doing this a few times in an incremental fashion, it occurred to me that maybe I should write a post about it. If markets are ready to resume an uptrend, then I am indeed late in advising readers to follow this strategy. If markets are headed down, it may not be too late to preserve a portion of remaining principal.

Blogging on the stock market can be challenging. Accuracy, insight and timeliness are crucial and often difficult to achieve.

James Morgan - Puritan Financial Advisor said...

A second goal is to preserve capital in uncertain times. When markets do rebound, the portfolio won't have to make up so much lost ground just to get back to break-even.

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