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Surviving 401(k) losses
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July 10, 2001: 4:23 p.m. ET
Rebalance your portfolio, don't chase performance, and diversify
By Staff Writer Shelly K. Schwartz
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NEW YORK (CNNfn) - If you listen closely, you can almost hear the collective sigh.
Mutual fund investors, still licking their wounds over last year's punishing blows, are getting their first glimpse of second-quarter financial statements this week only to find that their 401(k) plans are still wallowing in the mud. Few have made much progress in reversing earlier losses, despite new contributions, and some remain in the red.
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 Dan Kadlec, Wall Street columnist for Time Magazine, talks with CNNfn about 401 (k) losses. |
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According to Morningstar, a Chicago-based fund tracker, the average mutual fund returned just 4.62 percent for the three months ended June 30 – due to a flood of earnings warnings and continued weakness in the U.S. economy. Equity funds, both domestic and international, brought in 6.69 percent, while bond funds returned a miniscule 0.19 percent.
Adding insult to injury, the major market indexes show no signs of improvement heading into the third quarter.
The Nasdaq composite index fell 7.2 percent last week, widening its year-to-date loss to 18.8 percent, and the Dow Jones industrial average shed 2.4 percent, pushing its 2001 decline to 5 percent.
Bear markets are nothing new to Wall Street, of course, but the downturn that began in April 2000 has been an unwelcome surprise for many investors – especially younger ones -- who had grown accustomed to double digit gains.
"This is something you should expect. It's why you earn more in stocks, because you are compensated over the long-term for taking on more risk," said Amy Noel, a certified financial planner in Boulder, Colo., who notes that bear markets take control once every 5 years and usually last about 18 months. "That just means you have to learn to survive these dips. What's happening right now is very normal."
Noel said investors should treat the protracted downturn as a wake-up call, redoubling their efforts to strike a balanced portfolio. It does not mean you should bury your dollars in bonds.
"This is a great opportunity to look at your statements and reassess how much risk you want to take," she said. "These funds are on sale right now. If you are the average investor and you are young enough, you should see this as a buying opportunity and absolutely buy more."
In the driver's seat
401(k)s, which allow individuals to contribute pre-tax dollars into an investment account that consists of mutual funds and in some cases company stock, have fast become the retirement savings tool of choice, picking up where pension plans left off.
Such investment vehicles are favored because they lower your taxable income in the year you make a contribution and because many employers are willing to match 50 cents on the dollar, up to 6 percent of your salary. The dollars dropped into 401(k)s grow tax-deferred until withdrawn in retirement, at which point most individuals fall back into the lowest tax bracket of 15 percent.
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 TO THE MAX
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The contribution limit for 401(k)s is $10,500 this year. It will climb by $1,000 each year from 2002 through 2006.
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Another advantage of the 401(k) is that it puts individual investors in the driver's seat, allowing them to craft their own portfolios based on their time horizon, risk tolerance levels and long-term financial goals. But not everyone, it seems, is up to the challenge.
Cerulli Associates, a benefits research group, found that 401(k) plans are losing money for the first time in their 20-year history as investors overweight their holdings on high-risk equities and company stock. The average 401(k) account, it found, shrank to an estimated $41,919 last year, from $46,740 in 1999.
(Click here for a list of "Top 5 401(k) Pitfalls" to avoid.)
The group estimates those accounts have fallen another $600 since then, as Wall Street extends its slump and investors continue to chase past performance.
So what's an investor to do?
Morningstar analyst Russell Kinnel said the latest batch of disappointing quarterly results give investors an incentive to reacquaint themselves with their retirement plans.
Experts say you should work your way backwards. Start by identifying your financial goals and then develop an asset allocation strategy that will help you meet your needs when you bid farewell to the boss. Once the building blocks are in place, determine whether your current holdings fit the bill.
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ASSET ALLOCATION WIZARD
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Find the best mix of securities to help you meet your long-term needs.
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Every dog has its day
Kinnel warns it's unwise to chase individual sectors since peaks and valleys are unpredictable.
Some thought last year's downturn would take its toll on consumer cyclicals, including manufacturers and retailers which move in concert with economic performance. But it walloped tech and health care stocks instead.
The bear market before that, in the early 1990s, went after financials, which turned in their worst performance since the economic Depression in the late 1920s.
"You need to be diversified because you don't know which sector is going to get hit next," Kinnel said. "Just realize that nothing is ever that easy and that every recession is different."
So far this year, health-care stocks that help make up the S&P 500 index have lost 12.8 percent, while information technology (IT) stocks have lost 35.1 percent, according to Standard & Poor's sector scorecard.
Consumer discretionary stocks, or cyclicals, have lost 6.9 percent since Jan. 1 after gaining 24.1 percent last year.
A happy medium
Experts say retirement portfolios should contain a little of everything, including stocks, bonds and cash appropriate to your age and risk tolerance level. The younger you are, the more you can risk in equities, but be sure to maintain at least a mixture of small-, mid- and large-cap domestic stock funds and international funds.
Such a strategy will help you ride out any future ups and downs on Wall Street, and it just might help you sleep at night, too.
(Click here for the perfect model portfolio for you.)
"Building a 401(k) plan is not that hard; it's just that there are a lot of people who haven't had to do it before," Kinnel said. "For simple diversification, you just need, cash, bonds and stock. You also need to diversify between value and growth, foreign and domestic. The hard part is having the psychological make-up to stick to your plan and not chase performance."
Kinnel notes that investors are making a "tremendous mistake" if they select funds based on those that performed the best over the last 12 months. That strategy will only ensure that you perpetually buy the highest priced assets, which are most vulnerable to a downturn.
Same goes for investors who sink 100 percent of their holdings into company stock, which many employers offer as part of their 401(k) menu. Retirement plans that consist of a single company stock enjoy none of the diversification benefits that mutual funds provide. They are highly volatile and are among the most risky of all long-term investment options.
"You need to develop an investment plan and understand what risks you're taking," Kinnel said.
Still skeptical about the merits of diversification? Second-quarter performance data show that investors who owned small-cap funds as part of their balanced portfolio have generally done much better than those who remained loyal to their large-cap counterparts, according to Morningstar.
(Click here for our special report on the Road to Riches.)
Two small-cap funds that performed especially well last quarter include Bogle Small Cap Growth, which gained 16.38 percent, and Texas Capital, up 27.82 percent, bringing its year-to-date return to 20.05 percent. Not bad.
As an asset category, specialty-health funds performed the best during the second quarter, which ended June 30, returning 16.74 percent. Small growth funds came in second with 14.41 percent returns, while small blend funds brought in 13.41 percent. Industrial-cyclical and energy sector funds also turned in healthy returns.
In the domestic equity category, utility funds performed the worst, losing 2.67 percent during the three-month period, along with specialty-natural resource funds, which lost 1.11 percent. Funds that target the communications industry were the third-worst performer, gaining just 0.95 percent.
(Click here to create a solid retirement strategy using Money.com's "60-minute 401(k) tool".)
Reality check
Like most financial planners, Noel said long-term investors should remind themselves that a few bumps on the road to retirement are par for the course. Don't get hung up on the performance of your account on a quarterly basis and try to ignore the ups and downs.
Also, keep in mind that over their 20-year history, 401(k)s have returned an average of roughly 12 percent, which includes a few years of record returns and a few in which the markets fell flat.
Noel also suggests investors who are frustrated by their latest financial statements resist the urge to reduce contributions to their 401(k). Most investors, in fact, should do the opposite.
"You can compensate for what happened this year by upping your contribution next year," she said. "It may be hard, but you can always put the new money going in into bonds if it makes you feel more comfortable. You can honor the fact that you weren't as comfortable as you thought you were, especially those who invested heavily in company stock or technology."
Noel said it's doubtful those investors will recover within the decade, as some stocks are down nearly 80 percent.
"For those people have been really burned it takes a lot to get back to where you were. But those in a well-balanced portfolio are maybe down 10 percent or 20 percent right now and I feel fairly confident they will recover, Noel said.
If your 401(k) consists largely of company stock or a single sector today you should begin moving a portion of that investment into broader mutual funds over the next six months. "That way you don't try to guess when the prices are low," she said. "You dollar cost average."
As for how soon the markets will recover, that remains to be seen. Some economists predict a turnaround for the second half of the year, which should drive up the value of 401(k)s. In the meantime, diversify your assets, don't chase returns and don't count your chickens before they've hatched.
"Economists are expecting things to gradually improve but realize that we are in a tougher environment now," Kinnel said. "I expect that 3 to 5 years from now we'll have some respectable gains of 5 percent to 10 percent annualized returns, but don't build a plan for anything better than that." 
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