Those Who Do Best Are The Ones That Take Prudent Risks

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This post is for average 401(k) investors.  I’m going to let you in on a secret that is not so secret, but does not get talked about much.  It’s a simple idea as well, and would be common sense, if sense were common.

401(k) investors tend not to change their allocations often, except to panic when things are going bad, or arrive late in bull market, and buy near the top.  In general, if you don’t have a lot of investment knowledge, it is good to come to a place where you “set it, and forget it.”  Remember, those with no experience are far more prone to the errors of fear and greed than most experts are.  Those arrive late to a rise or a fall in the market, and say, “Look what I have missed out on,” or ‘Look at how much I have lost,” are going to make the wrong move again and again.

There are temptations as an investor to not diversify.

  • “I’ll just hold all my assets in a money market fund.  I don’t want to lose anything.”  Money market funds preserve value at best.  They won’t help you build value.
  • “I’ll just hold all my assets in gold.  I don’t want to lose anything.”  Gold preserves value at best.  It won’t help you build value.
  • “This manager is the greatest.  I’m putting it all on him.”   Sadly, managers have hot and cold streaks.  Many people join in near the end of hot streaks.  The quote I heard this from was a professional in 1999, deciding to invest all his money with Bill Miller.  Bad timing.
  • “Stocks win in the long run.  I am investing only in stocks.”  If you have a really long time horizon, and you are certain that your nation will not go through a revolution, or something close to it, that will work.  Otherwise, you are taking a risk.

There are more, but I think you get the point.  In most of life, those who do the best are the ones that take prudent risks.  Prudent risks are where the likely rewards outweighs the likely risks.

Think of it: in business, the guy who never takes risk does not do well.  The guy who takes huge risks blows up frequently, and does not do well on average.  The guy who takes moderate, prudent risks tends to do well.

The same is true of bond investing.  Those who invest in bonds of medium risk (BBB/Baa) tend to do best, those that play it safe or risk it all do less well.

The same is true of stock investing.  Stock investing is risky by nature, and in general, those who take less risk tend to earn better returns over time.  Ignore the canard: more risk, more return.  It ain’t so.

So what would I do if I were a 401(k) investor facing a limited menu of choices?

  • Put 60-70% in conservative, value-oriented stock funds. (US and Foreign)
  • And 25-35% in moderately risky bond funds. (US and Foreign)
  • And 5% in cash.
  • And rebalance yearly.  Do it after you complete your taxes, or something like that.

Avoid complexity.  Even if the plan offers a wide number of choices, winnow it down to a few funds, say five at most.  Over the long run, your investments should prosper, because you are doing things that few investors will do, and enjoy  returns from bearing risk successfully.

By David Markel CFA of alephblog

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