The inspiration for this Blog post was an article describing how mobile apps for 401k retirement plan accounts are becoming very widely used by plan participants. It’s been available for a long time, and now with more younger users who do almost everything online - it is exploding. That means participants, constantly watching their 401k balances, may be tempted to make moves that harm their long term returns.
Originally my Blog Post title was going to blame technology. I realized that to blame technology is unfair to technology. As Jimmy Buffett wrote in Margaritaville, “Some people claim …..to blame, But I know it's my own damn fault.” It’s the human behavior to information they see via technology that are to blame here.
How does technology destroy wealth? Multiple ways, but first let me remind you, how investing works.
Invest in stocks in a highly diversified manner in low cost mutual funds or exchange-traded funds. Keep saving and investing over the long term. Once you get to 20 years, your annualized return should be around 10%/year. Each individual year, the return bounces around. With less than 20 years of data, your annualized return could be above or below 10% - but as you continue adding years, the return continues moving closer to the 10% area. Do not pull money in and out as you will likely get a lower return. So inaction is preferred to action with respect to changing investment strategy, once you are invested.
What I just described is true and backed by huge amounts of data.
How does technology hurt:
Many of us are predisposed to “taking action” and technology can cause that behavior. People watch the markets rise and fall on their smartphones accompanied by emotional discussion and they can’t resist taking action. Nervous energy is one of the worst causes of wealth loss! These actions inevitably lead to them experiencing lower returns. Yes, it’s possible some short term moves might actually improve results at least temporarily, and it’s not out of the realm of thinking that long term someone might be very fortunate and do well. Historically these “wizards” are rare and impossible to identify in advance. In 401k plans, investors could be tempted to put money in a “safe” or “stable” fund and while that could work over brief periods if timing is good - most people leave it there and miss out on major market moves and are stuck with a very low almost zero return.
Misinformation. The truths about how to successfully use the markets to grow wealth are constantly under siege. It’s important for everyone to return to factual, statistically valid numbers. Most people are not very good with numbers, and they don’t get help from someone that can explain the numbers and what they mean in terms of practical action that should (or should not) be taken. There are a number of subcategories under the Misinformation label. If you need a fresh dose of TRUTH with real numbers on how the market behaves, even if you’re not a client, I am here for YOU! I also recommend our series of 6 brief “Market Storytelling” videos at https://www.youtube.com/@Trusted_Advisor.
Focus on short term investing instead of long term planning. This could be shown as one of the “Misinformation” subcategories. If you ask the average person about financial planning, they will describe it as being almost 100% about investing because this is the content they consume on the internet and social media. Wrong. When you undertake typical financial planning that projects future cash flows, it takes into account a wide range of market, tax and inflation outcomes, and develops a realistic range of outcomes. This helps families look at the “worst case scenario” of running out of money in retirement.
This next section is a little bit off topic, but it goes to how misinformation hurts growth of wealth - in this case in 401k plans.
Many funds (whether mutual funds or ETFs) are “actively” managed, meaning that they do research and choose specific stocks and the timing of their purchase and sale, hoping to beat a “passive” strategy. They have low diversification as well. It’s well documented that though in any one short time frame such as one year, they can “win”, but most of the time their performance is less than the passive (higher diversification) alternative.
In fact studies have shown that quite often, a very highly ranked mutual fund one year, will have a very low relative performance the next year. It makes sense because the fund adopted a strategy that was luckily successful in year one, but the market’s behavior changed in year two and the fund managers did not successfully use their crystal ball to move to a better investment strategy in year two. The reverse is true too. Often a relatively poorly performing fund in year one, will move up significantly in relative performance rating in year two!
A basic outcome then is that “past performance is not a good indicator of future performance”, which is why you see this legal disclaimer so often. It is true.
Why does this matter? Some companies have 401k plans where a committee of company employees, sometimes with the help of a broker, evaluate the fund lineup and then make decisions to change out funds because they recently performed poorly and ADD replacements because they recently performed well! Sounds reasonable until you realize that “past performance is not a good indicator of future performance”. Yet, so many 401k plans are run this way. It’s astounding! (The best way to run a 401(k) plan is to have an ERISA Section 3(38) investment manager that completely takes over the fund lineup selection and maintenance. They are experts and also officially shoulder the responsibility, reducing your liability. Never ever have a 401k without an ERISA 3(38) investment manager!)
Thanks for reading and have a great day!