Thursday, September 02, 2004

401k Investors can do more harm to themselves than good...

Amy Monahan at the University of Missouri School of Law has written a paper about how investors in 401ks can be inefficient. From the abstract
The article begins by identifying two common types of imperfect actors, the impatient and the impulsive, and describing the behavioral characteristics common to each. Relying on several studies of savings behavior in 401(k) plans, the author describes four common mistakes that imperfect actors are likely to make in 401(k) plans that may endanger their retirement wealth. The author then proposes a multi-part legislative solution to the common problems identified, in order to better protect imperfect actors in 401(k) plans.

At the risk of exhibiting small sample bias, I can say that I've seen this with many friends and relatives, especially the younger ones who have just started working in the last decade. The attitude many people have about their 401k, IRA, etc. is that it is essentially play money, since they can't spend it. Since they have a long enough time horizon they should be aggressive with it. They argue that it will grow faster that way. They typically invest it in things like technology funds, or small-cap growth funds, or the mutual fund du jour; arguing that over time these funds will give them higher returns. They fail to realize that what these funds have is a higher risk profile, and higher volatility, so you have the potential for higher gains. You also have the potential for ruin.

Think of it this way; It's the year 1700 and you live in Italy. You want to get to America. You know there are about 100 ships leaving port this month and of these about fifty are small, nimble ships that will get there very quickly, and fifty are these huge, monolithic galleons that will go very slow in the water. The nimble ships would be the obvious choice, except if you hit a serious storm (which occurs every once in awhile) you will surely drown. The bigger ships go slower, but have a greater chance of surviving a storm.

The key factors should be your needs and your time profile. If you are fleeing the castle guard for stealing the king's crown and need to get to America quickly, you would choose the small boats. If you are moving your family and all your possessions to the New World, you should probably choose the large boats. But to base your decisions on the basis that the majority of small boats makes it to the New World faster than the majority of the large boats is absurd.

The thing most people I've talked to can't get through their head is that if you lose 50% of your wealth, you need a subsequent 100% gain to make it up.

Link via [tax prof blog]


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